On October 30, the SEC completed a two-year effort to implement the exemption from Securities Act registration for “crowdfunding” securities offerings contained in Section 4(a)(6) of the Act by adopting Regulation Crowdfunding in substantially the form it had proposed. Crowdfunding is a method used by start-ups and other small businesses to raise money through solicitations on the Internet. These enterprises historically have raised funds primarily by soliciting donations or advance purchases of finished products. The new regulation will allow them to expand their fundraising methods by soliciting investments in their securities through a registered broker or a “funding portal" acting as an intermediary between the issuer and investors.
The new regulation is the product of the Jumpstart Our Business Startups Act of 2012 (commonly known as the JOBS Act), which added Section 4(a)(6) to the Securities Act. Its requirements and restrictions are described in the SEC’s 686-page Release No. 33-9974. The regulation will become effective 180 days after publication in the Federal Register, except for the forms necessary for funding portals to register with the SEC, which will become effective on January 29, 2016.
Principal features of the regulation
The new regulation represents an effort by the SEC to balance the financial constraints of crowdfunding issuers, which generally have limited resources to devote to securities-law compliance, with the need to protect the interests of crowdfunding investors, many of whom are expected to be relatively unsophisticated concerning securities investments. This balancing is evident primarily in a relaxation in the final regulation of some of the disclosure and financial statement requirements initially proposed by the SEC. The primary components of the regulation are the following:
Offering limit. An eligible issuer may sell up to $1 million of securities during a 12-month period. Offerings by an eligible issuer under other Securities Act exemptions made in close proximity to an offering under the new regulation will not be integrated with a crowdfunding offering and therefore will not reduce the amount that can be raised.
Ineligible issuers. The new regulation states that it cannot be relied upon by any of the following types of entities:
- Non-U.S. companies
- Companies that file reports under the Exchange Act
- Investment companies
- Certain investment funds excluded from the definition of “investment company” under the Investment Company Act
- Companies disqualified from relying on the new regulation, including “bad actors”
- Companies that previously made a crowdfunding offering but did not file an ongoing annual report that was due during the two years immediately preceding the filing of a required new offering statement
- Companies that have no business plan or have indicated that their business plan is to engage in a merger or acquisition with an unidentified company or companies
Manner of offering. Crowdfunding transactions will have to be conducted through the electronic platform of an intermediary that is either a registered broker or a registered funding portal. An issuer will be able to use only one intermediary for a particular offering or concurrent offerings made under the new regulation. No restrictions on sales to non-accredited investors will apply, although offers and sales of securities will be subject to the antifraud provisions of the federal securities laws and to state registration and offering requirements.
Issuer requirements and limitations
Regulation Crowdfunding does not stray far from the basic mandates of the JOBS Act. In addition to requiring eligible issuers to conduct their crowdfunding offerings through an intermediary, the regulation limits their promotional and advertising efforts and imposes disclosure requirements on them by requiring both an offering statement and follow-up progress reports and annual reports. Insignificant deviations from the regulation will not be a basis for denying the exemption to an issuer that exhibits good faith and a reasonable effort to comply.
Use of intermediary’s platform. Crowdfunding transactions must be conducted through the electronic platform of the intermediary, and an issuer can use only one intermediary for a particular offering or concurrent offerings. In response to public comment on the rule proposal, the SEC modified the definition of “platform” to encompass any “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.”
Promoter compensation. An issuer may compensate a person to promote its crowdfunding offering if the promoter engages in its promotional efforts through the intermediary’s platform and the issuer takes reasonable steps to ensure that the promoter clearly discloses the receipt of its compensation in every promotional communication.
Advertising restrictions. The regulation permits limited advertising of crowdfunding offerings in an offering notice similar to tombstone ads permitted under Securities Act Rule 134. The notice will be required to direct an investor to the intermediary’s platform through which the offering is being conducted. An issuer also may communicate with potential investors if the communications occur through the intermediary’s platform, so long as potential investors are advised directly of any platform communications being made by the issuer or on the issuer’s behalf.
Offering statement disclosure requirements. The issuer is required to file with the SEC, and the intermediary is required to post on its platform or provide a link to, an offering statement on new Form C containing information about the issuer, the intermediary and the offering. The offering statement must include, among other disclosures:
- A description of the issuer’s business and its intended use of the proceeds from the offering
- The price of the securities or the method of determining the price, the deadline for reaching the target offering amount and whether the company will accept investments exceeding the target amount
- A narrative discussion of the issuer’s financial condition, which must include (to the extent material) disclosure regarding indebtedness, liquidity, capital resources and historical results of operations
- Financial statements and relevant tax information of the issuer that are either (a) certified by the issuer’s principal executive officer (offerings of $100,000 or less), (b) reviewed by an independent public accountant (offerings above $100,000 up to $500,000) or (c) audited by an independent public accountant (offerings above $500,000), except that a first-time issuer offering more than $500,000 but less than $1 million may provide financial statements reviewed (but not audited) by an independent public accountant if audited financial statements are not otherwise available
- A description of risk factors that make the offering speculative
- Information about the officers, directors and 20% owners of the issuer, and any related-party transactions
- The name, SEC file number and Central Registration Depository number, as applicable, of the intermediary through which the offering is being conducted
- The amount of compensation paid to the intermediary, and a description of the intermediary’s financial interests in the transaction and in the issuer
- A description of all exempt offerings undertaken by the issuer within the past three years
- The location on the issuer’s website where investors will be able to find the issuer’s annual report, and the date by which it will be available
Any material changes by the issuer to previous disclosures made by it must be filed with the SEC and made available to investors as amendments to Form C, and the issuer must obtain reconfirmations from each investor when it makes those changes.
Follow-up disclosure requirements. The following additional disclosures by the issuer will be required regarding the offering:
Progress updates. An issuer must file a progress update with the SEC on new Form C-U in connection with the closing of the offering and, unless the intermediary provides frequent progress updates on its platform, within five days after receiving commitments for 50% of the offering and after receiving commitments for the full offering.
Annual reports. An issuer also will have to file with the SEC and post on its website, within 120 days after the end of each fiscal year of the issuer, an annual report on new Form C-AR and financial statements of the issuer certified by its principal executive officer. The annual report must include the same type of information required in the offering statement. As modified in the final rules, the annual reporting requirement continues until the issuer first:
- Becomes a reporting company under Section 13(a) or 15(d) of the Exchange Act
- Has filed at least one annual report and has fewer than 300 holders of record
- Has filed at least three annual reports and has total assets that do not exceed $10 million
- Has repurchased all of the securities issued in the crowdfunding offering
- Has liquidated or dissolved its business in accordance with state law
Investor requirements and limitations
To reduce the risk of loss by investors in a crowdfunding offering and to conform to JOBS Act requirements regarding resales of the offered securities, Regulation Crowdfunding limits the amount of money a person may invest individually, requires that each investor open an account through which specified information is available, provides cancellation rights to investors and restricts transfers during the year following the purchase of securities in the offering.
Investment limits. The regulation restricts in the following manner the amount of securities an investor may purchase in a 12-month period based on the annual income or net worth of the person and the person’s spouse:
- An investor with either an annual income or net worth of less than $100,000 may purchase securities with a value up to the greater of $2,000 or 5% of the lesser of the investor’s annual income or net worth
- An investor with both an annual income and net worth of at least $100,000 may purchase securities with a value up to 10% of the lesser of the investor's annual income or net worth, not to exceed $100,000 in the 12-month period
The investment limit applies in the aggregate to all investments by the investor in crowdfunding offerings during a 12-month period, rather than to each individual offering in which the person invests.
Account opening. An investor will be required to open an account with the intermediary and consent to electronic delivery of materials. The intermediary then must make available to the investor specified information, including educational materials explaining the offering process and applicable restrictions and limitations, by electronic message that either includes such information, provides links to the information on the intermediary’s platform or provides notice that the information is on the intermediary’s platform or the issuer’s website.
Cancellation rights. An investor will have an unconditional right to cancel an investment commitment for any reason until 48 hours before the offering deadline identified in the issuer’s offering materials. During the final 48 hours before the deadline, cancellation will be permitted only if there is a material change to the offering terms or to other information provided by the issuer regarding the offering.
Resale restrictions. An investor may not transfer securities purchased in a crowdfunding offering for one year after purchase, except to the issuer, an accredited investor, a buyer in a resale offering registered under the Securities Act or a family member, or in connection with the investor’s death or divorce. Holders of the securities would not count toward the threshold number of recordholders that requires an issuer to register a class of equity security under Section 12(g) of the Exchange Act if the issuer is current in its annual reporting obligations, retains the services of a registered transfer agent and has less than $25 million in total assets as of the end of its most recently completed fiscal year.
Intermediary requirements and restrictions
The regulation requires that an issuer’s crowdfunding transaction be conducted online through the platform of a single intermediary, in order to foster the creation of a “crowd” for the sharing of information and the evaluation of the idea or business that is the basis of the crowdfunding effort.
Intermediary qualifications. The regulation requires an intermediary in a crowdfunding offering to:
- Register with the SEC as either a broker or a new type of SEC registrant called a “funding portal”
- Be a member of the Financial Industry Regulatory Authority (FINRA) or any other registered national securities association
- Prohibit its associated persons (its directors, officers or partners, or persons having a similar status or performing similar functions) from having any financial interest in an issuer that is using the intermediary’s services or receiving a financial interest in an issuer as compensation for the service provided to or for the benefit of the issuer in connection with the offering
- Not have a financial interest of its own in an issuer that is using its services unless (a) the intermediary receives the financial interest from the issuer as offering compensation and (b) the financial interest consists of securities of the same class and having the same terms as those sold in the offering
Funding portal restrictions. A funding portal may act as an intermediary without registering with the SEC as a broker, so long as it (a) becomes a member of FINRA or another registered national securities association and (b) files a “Form Funding Portal” document with the SEC containing information generally consistent with (but not as extensive as) the information required for broker-dealers registering on Form BD. Neither a funding portal nor its associated persons may:
- Offer investment advice or recommendations
- Solicit purchases, sales or offers to buy the securities displayed on its platform
- Compensate parties for solicitation efforts or sales of securities displayed or referenced on its platform
- Hold, manage, possess or otherwise handle investor funds or securities
- Engage in other activities that the SEC determines by rule to be inappropriate
The regulation provides a safe harbor under which funding portals may engage in certain “permitted activities” consistent with these restrictions.
Duties of intermediaries. Among its numerous duties, an intermediary is required to:
- Make the requisite offering information publicly available on its platform for 21 days before any sales are made
- Have a reasonable basis for believing that prospective investors will satisfy applicable investor limitations
- Provide communications channels on its platform for persons to communicate with one another and with issuer representatives regarding offerings available on the platform
- Furnish to a person who has made an investment commitment a written notification of the commitment
- Conform to specified procedures for the maintenance and transmission of funds
- Provide each investor in the offering with a written confirmation of the investment by e-mail or other electronic media at or before the completion of the offering
- Advise investors of material changes to the terms of the offering or the information provided by the issuer and indicate to each investor who has made an investment commitment that the commitment will be canceled unless the investor reconfirms the commitment within five business days
- Notify investors within five business days of a determination not to complete an offering, the reason for the determination and the amount of the refund the investor is expected to receive
- Provide disclosure to investors about the intermediary’s compensation
Fraud prevention. An intermediary is required to take the following steps to minimize the possibility of fraud in a crowdfunding offering:
- Have a reasonable basis for believing that the issuer makes available to the SEC, prospective investors and the intermediary specified information regarding the offering
- Have a reasonable basis for believing that the issuer has established a means for keeping accurate records of the holders of securities acquired through the intermediary’s platform
- Deny access to its platform if it has a reasonable basis for believing that (a) the disqualification provisions of the new rules would apply to the issuer or any of its officers, directors or 20% holders or (b) the issuer or the offering raises concerns about potential fraud or investor protection
- Conduct a background and securities enforcement regulatory history check on each issuer whose securities are to be offered by the intermediary, as well as on each of its officers, directors and 20% holders
Although the SEC made significant changes to the financial statement requirements and other proposed requirements of Regulation Crowdfunding in response to public comments, the regulation is unavoidably complex due to the extensive standards dictated by the JOBS Act. This complexity, together with the relatively low limit of $1 million on the amount of capital that may be raised in a crowdfunding offering, raises concerns about how useful the crowdfunding method of raising capital will be to the entrepreneurs and small businesses to which it is directed. Indeed, the lone SEC Commissioner who voted against adoption of the regulation expressed concern that, as a result of its complexity, “many traps for the unwary are hidden in the regulations, creating potential nightmares for small business owners that fail to place regulatory compliance at the top of their business plans.”
Regulators and other interested parties also have expressed concern that the new regulation will be misused to defraud unsophisticated small investors. To address this concern, the SEC built into the regulation the concept of intermediaries that will serve as guardians against fraud. Major investment banking firms, however, have indicated a lack of interest in expending their resources on the operation and oversight of small crowdfunding offerings, so it may be that many intermediaries will be small firms that have limited experience and resources to fulfill their responsibilities. It remains to be seen how effective they will be in preventing fraud and performing their administrative functions.
Notwithstanding these concerns, the regulation opens up a fundraising avenue for small businesses that previously was unavailable. The regulation could be particularly useful for entities that do not have access to bank loans or other private funding sources. But it is undeniable that the regulation is an experiment whose worth will not be capable of assessment until there have been numerous offerings made in reliance on the new offering regime.