On October 30, 2015, the Securities and Exchange Commission (SEC) adopted final rules to implement equity crowdfunding under Title III of the 2012 Jumpstart Our Business Startups Act (JOBS Act). “Regulation Crowdfunding,” which was approved by a three to one vote of the Commissioners, sets forth rules under which small businesses and startups can raise equity and debt capital in a crowdfunded securities offering conducted through a funding portal using the Internet. For the first time, individual investors will have the opportunity to invest a relatively small dollar amount of capital in securities offered by businesses on the Internet, without meeting any financial or sophistication test, using the “crowd” to share information.
One of Congress’s express purposes in passing the JOBS Act was to foster capital formation by small businesses, but Title III crowdfunding has proven to be controversial. Some critics have expressed concerned that the cost of raising capital in a crowdfunded offering is high compared to the dollar amount of capital that issuers can raise using this platform. Other critics have raised concern about the potential for fraudulent issuers to exploit the relatively unsophisticated investors likely to invest in crowdfunded offerings. The SEC attempted to address these competing concerns in the new crowdfunding rules, but had only limited ability to do so because many of the crowdfunding requirements are set forth in Title III of the JOBS Act.
Title III of the JOBS Act added Section 4(a)(6) to the Securities Act of 1933 (Securities Act), which provides a new exemption from federal securities registration requirements for securities offered and sold in crowdfunded offerings under Title III and the SEC’s rules. The JOBS Act provides, in part, that:
- Issuers are permitted to raise a maximum of $1 million in crowdfunding offerings in any 12-month period;
- Investments by an individual during any 12-month period are limited to an aggregate maximum for all crowdfunding offerings as follows:
- For individuals whose annual income or net worth is less than $100,000, the greater of (a) $2,000 or (b) 5 percent of their annual income or net worth, whichever is less; or
- For individuals whose annual income and net worth are each at least $100,000, 10 percent of their annual income or net worth, whichever is less; up to a maximum aggregate amount of $100,000; and
- Transactions must be conducted either through a registered broker-dealer or through a new registered entity call a “funding portal.”
Title III also includes a requirement that issuers and intermediaries that facilitate transactions disclose certain information to investors and prospective investors, and provide certain notices and other information to the SEC. Under Title III, the SEC is required to adopt rules to exempt “funding portals” from the requirement to register under Section 15(a)(1) of the Securities Exchange Act of 1934 (Exchange Act) as broker-dealers, and establish rules that will disqualify certain issuers from relying on the crowdfunding exemption in Section 4(a)(6) of the Securities Act if the issuer or the intermediary is subject to a disqualifying event.
SEC Crowdfunding Rules
The SEC originally proposed rules to implement crowdfunding under the JOBS Act in October 2013. The SEC received over 485 comment letters from a wide variety of interested parties which it considered in adopting the final rules.
Issuers that conduct a crowdfunded offering pursuant to Section 4(a)(6) of the Securities Act will be required to file certain information with the SEC and make that information available to investors and prospective investors. In a change from the rules as originally proposed, issuers will be permitted to provide the required information in a Q & A format. The information required to be disclosed in the offering documents includes:
- Information about the officers, directors and 20 percent or greater stockholders of the issuer;
- A description of the issuer’s business and the proposed use of proceeds;
- The price or the method of determining the price of the securities, the target offering amount and the deadline to reach the target offering amount;
- Certain related-party transactions;
- A discussion of the issuer’s financial condition; and
- Financial statements of the issuer that are accompanied by certain information from the issuer’s tax return (for offerings of up to $100,000), reviewed by an independent public accountant (for offerings of up to $500,000) or audited by an independent auditor (for offerings of $500,000 or more).
In response to comments received on the crowdfunding rules as originally proposed, the SEC changed the requirement relating to financial statements to permit first time crowdfunding issuers for an offering of $500,000 or more to provide reviewed financial statements rather than audited financial statements (unless the issuer has audited financial statements available). In addition, the SEC will not require issuers in offerings of up to $100,000 to file or make publicly available their tax returns, but rather will permit issuers to disclose certain information derived from their tax returns.
Issuers that rely on Regulation Crowdfunding will be required to file annual reports with the SEC and provide those reports to investors. Information required to be disclosed in the annual reports includes financial statements.
Certain issuers are not eligible to use the crowdfunding exemption, including non-U.S. companies, companies that are already Exchange Act reporting companies, certain investment companies, companies that are subject to disqualification under the new crowdfunding rules, companies that failed to comply with the annual reporting requirements during the two years preceding the filing of the offering statement that is required in connection with a crowdfunded offering, and companies that do not have a specific business plan or indicate that their business plan is to engage in a merger or acquisition with an unidentified company. Issuers are permitted to conduct crowdfunded and concurrent offerings through only one funding intermediary at a time.
Securities acquired in a crowdfunded offering generally are subject to a one-year holding period before they can be resold. Holders of these securities do not count toward the threshold that requires an issuer to register its securities under Section 12(g) of the Exchange Act if the issuer is current in its annual reporting obligation, retains the services of a registered transfer agent and has less than $25 million in assets.
Under Title III, crowdfunding offerings must take place either through a broker-dealer registered with the SEC or through a new registered intermediary called a “funding portal.” Funding portals will be required to register with the SEC and with the Financial Industry Regulatory Authority (FINRA).
Under Regulation Crowdfunding, these intermediaries are required to:
- Provide investors with educational materials;
- Take certain measures designed to help reduce the risk of fraud, such as conduct background checks on issuers as well as their directors and officers;
- Make information available about the issuer and the offering on the platform for a minimum of 21 days;
- Provide investors with channels to communicate with each other about and discuss the offering, the so-called “crowdfunding” aspect of the offering; and
- Facilitate the offer and sale of the crowdfunded securities.
Crowdfunding portals are prohibited under Regulation Crowdfunding from:
- Offering investment advice;
- Soliciting purchases, sales or offers for securities offered on their platform;
- Compensating any third party based, directly or indirectly, on the purchase or sale of a security offered in reliance on the crowdfunding exemption; and
- Holding, possessing, or handling investor funds or securities.
Recognizing the role that crowdfunding portals can play in eliminating fraud in the crowdfunding securities market, the crowdfunding rules also provide registered intermediaries with flexibility to exclude issuers from their site.
Regulation Crowdfunding will be effective 180 days after publication in the Federal Register, which should make the rules effective in May 2016, although the new forms for registration as a funding portal will be effective on January 29, 2016. The SEC also directed its staff to undertake a study within three years of the effective date of the new rules on the impact of the regulations on capital formation and investor protection, as well as how the crowdfunding market develops.