By Sabari Bagchi, Esq. and Danielle Comanducci, Esq.
On October 23, 2013, the Securities and Exchange Commission (the “SEC”) released proposed rules to implement the requirements of Title III of the Jumpstart Our Business Startups Act (the “JOBS Act”) aimed at helping startups and small businesses raise investment capital and sell securities using the Internet. These rules set the terms for what is called “New Regulation Crowdfunding.” Crowdfunding is an evolving method to raise money using the Internet under which the general public, including non-accredited investors, would be allowed to invest limited amounts to purchase unregistered securities of small businesses. Certain private companies would be permitted to raise investment capital online for a particular business or other venture, usually by seeking relatively small individual contributions from a large number of investors. As the practice evolves, a more level playing field may emerge in which ordinary people may fundraise or invest, regardless of personal wealth or access to wealthy investors.
New Regulation Crowdfunding would (1) prescribe rules governing the offer and sale of securities under Section 4(a)(6) of the Securities Act of 1933 (the “Securities Act”), (2) exempt securities sold pursuant to Section 4(a)(6) from the registration requirements of the Securities Exchange Act of 1934 and (3) provide a framework for the regulation of registered funding portals and intermediaries. These proposed rules do not limit the types of securities that may be offered in reliance on the crowdfunding exemption, and thus, any form of security may be eligible, including equity and debt securities.
It is important to note that the proposed rules are not yet effective, and the SEC has warned that any offers or sales of securities purporting to rely on the crowdfunding exemption would be unlawful under the federal securities laws. Accordingly, until the SEC’s rulemaking is complete and New Regulation Crowdfunding becomes the law, small businesses and startups should continue to use the current rules for private placements to structure their transactions.
While there are certain websites that allow the public at large to make investments, such as www.indiegogo.com, peerbackers.com, or www.kickstarter.com, these websites provide a way to raise capital for projects, businesses or other ventures through means that do not involve the sale of securities. Instead these current crowdfunding websites often involve contributions or donations from the public in exchange for products or services relating to a certain project, business or venture. Most importantly, these websites do not offer the public a share in any financial return or profit that may constitute a security, which would currently need to be registered under the Securities Act or qualify for an exemption under the rules for private placements. Other so-called crowdfunding sites that currently operate, merely facilitate private placements to accredited investors under existing rules for private placements.
The Proposed Rules
The SEC’s proposed rules are complex and run approximately 585 pages. This article highlights certain key aspects of the proposed rules and is not intended, and should not be relied upon, as a complete summary.
The proposed rules set forth “a regulatory framework for the intermediaries that would facilitate the crowdfunding transactions” and specify who may invest, how much can be invested and the information that companies would be required to provide in their offering documents.
Under the proposed rules, eligible companies would be able to raise a maximum aggregate amount of $1 million in any 12-month period through crowdfunding. For the purposes of calculating the $1 million limit, a company must aggregate the amount of securities that it proposes to issue with the amount of securities sold by entities controlled by or under common control with such company in reliance on the crowdfunding exemption during that same 12-month period.
Individual investors may invest:
- The greater of $2,000 or 5% of their annual income or net worth, if both their annual income and net worth is less than $100,000; or
- The greater of 10% of their annual income or net worth, if either their annual income or net worth is equal to or more than $100,000. However, during any 12-month period, these investors would not be able to purchase more than $100,000 of securities through crowdfunding.
It is important to note that the proposed rules specify that, subject to certain exceptions, securities purchased in a crowdfunding transaction may not be resold for a period of one year.
Under the proposed rules, crowdfunded offerings would be conducted exclusively online through platforms operated by a registered broker or a funding portal, a new type of SEC registrant. All crowdfunding transactions would be conducted exclusively through such intermediaries’ websites or other similar electronic medium (i.e. platform).
These intermediaries would be required to (1) provide investors with educational materials, (2) implement fraud reducing measures, (3) make available information about the company and the offering, (4) provide communication channels to permit discussions about offerings on the platform and (5) facilitate the offer and sale of crowdfunded securities. The proposed rules would prohibit funding portals from (1) offering investment advice or making recommendations, (2) soliciting purchases, sales or offers to buy the securities offered or displayed on its website, (3) compensating certain people for solicitations and (4) holding, possessing, or handling investor funds or securities.
In addition, the JOBS Act and the proposed rules require that crowdfunding intermediaries be either a registered broker-dealer or a registered funding portal and be a member of a self-regulatory organization, which currently would be the Financial Industry Regulatory Authority (FINRA).
FINRA has also published its own proposed “Funding Portal” rules that would apply to future SEC registered funding portals which would become FINRA members pursuant to the crowdfunding provisions of the JOBS Act.
Disclosure by Companies
Companies raising capital through crowdfunding would have to file certain information with the SEC as well as provide it to investors and the relevant intermediary. Such disclosure would include a broad range of information such as:
- Identities of the company’s directors, officers and of owners of more than 20% of the company;
- Information regarding the company’s business and its intended use of the proceeds from the offering;
- Price to the public of the offered securities;
- Risk factors relating to the offering;
- Target offering amount;
- Description of the securities being offered;
- Certain related party transactions;
- Compensation to be paid to the intermediary; and
- Information regarding the financial condition of the company (e.g. capitalization and existing debt).
In addition, companies seeking to take advantage of the crowdfunding exemption would be required to provide potential investors with audited financial statements that, depending on the amount of the securities that the company is offering, would need to be certified by the company’s principal executive officer or by an independent public accountant. Companies would also be required to provide a narrative discussion of historical results of operations, in addition to information about liquidity and capital resources.
Restrictions of Advertising
Under the proposed rules, a company would generally not be permitted to advertise, directly or indirectly, the terms of a crowdfunded offering. However, there is a limited exception under which a company may publish a notice advertising the terms of the offering if such notice only includes: (1) a statement that the company is conducting an offering, the name of the intermediary through which the offering is being conducted and a link directing potential investors to the intermediary’s platform, (2) the terms of the offering and (3) factual information limited to the name, address, phone number and website of the company, the e-mail address of a representative of the company and a brief description of the company’s business. The notice must also direct investors to the intermediary’s platform through which the offering is being conducted and on which additional information about the company and the offering may be found. “Terms of the offering” would include (1) the amount of securities offered, (2) the nature of the securities, (3) the price of the securities and (4) the closing date of the offering period.
The SEC has stated that it is not proposing to impose limitations on how a company chooses to distribute these notices. For example, companies may place notices in newspapers or post notices on social media sites. The SEC believes this approach will allow companies to leverage social media to attract potential investors, while at the same time protecting potential investors by limiting the ability of companies to advertise the terms of the offering without providing the required level of disclosure.
In addition, under the proposed rules no direct or indirect compensation may be paid by a company to any person in connection with promoting a crowdfunded offering through communication channels provided by the intermediary unless the company takes reasonable steps to ensure that the person clearly discloses the receipt (both past and prospective) of compensation each time the person makes a promotional communication.
Not All Companies Would Be Able to Take Advantage of the Crowdfunding Exemption
Some companies would not be able to take advantage of the crowdfunding exemption. These companies include non-US companies, current SEC reporting companies, certain investment companies, companies that are disqualified under the proposed disqualification rules, companies that have failed to comply with the annual reporting requirements in the proposed rules and companies without specific business plans or those whose business plan is to merge with or acquire an unidentified company.
The Public Weighs in on the Proposed Rules
On February 3, 2014, the SEC closed the 90-day comment period during which the public submitted comments to the SEC on the proposed rules. While the SEC received many comments, this article will highlight some of the comments relating to the most controversial aspects of the proposed rules.
Many comments focused on, and took issue with, the limits imposed on investors. As stated above, a company would not be permitted to raise more than $1 million and individual investors would not be able to purchase more than $100,000 of securities through crowdfunding in any 12-month period. Some of the comments submitted to the SEC argued that these limits should be interpreted as a cap for investment into one company only and not a cap on the aggregate amount of funds that an investor can invest in all companies via crowdfunding. Some commentators expressed additional concern that these limits could potentially leave inadequate proceeds for investment in a company’s activities after it covers the costs of the initial offering (e.g. the costs a company would incur for the involvement of advisors, attorneys, auditors, intermediaries and others). The SEC has estimated that the initial cost to companies for crowdfunded offerings may range from $35,350 to $65,350 for offerings of between $100,000 and $500,000 and $72,200 to $147,200 for offerings of more than $500,000. Certain of these commentators suggested that either the SEC should raise the maximum annual offering limit or, alternatively, re-evaluate whether the level involvement of advisors or other professionals can be reduced or eliminated without unduly increasing the risk to investors.
Other commentators raised concern that the disclosure requirements contained in the proposed rules (e.g. that companies file ongoing, detailed disclosure reports including financial statements) are overly burdensome and fail to provide an optional simplified disclosure format. These commentators are urging the SEC to implement in its final rules more appropriate, less burdensome disclosure requirements enabling investors to evaluate the merits of an investment without unduly burdening companies with preparing expensive disclosure documents.
In addition, certain commentators, such as the online investment platform AngelList, took issue with the fact that the proposed regulations “don’t allow companies to test the waters by seeing what investor interest would be before bearing the regulatory expense” of complying with the new regulations. Instead, AngelList asserted that “the same investor protection goals could be met by requiring the disclosures, bad actors checks, etc., 15 days before accepting cash rather than before just soliciting interest.”
The impact of the public’s comments to the proposed rules remains to be seen. The SEC is now tasked with reviewing the public comments prior to enacting final rules later this year.