Overview On October 30, 2015, the US Securities and Exchange Commission (“SEC”) adopted final rules under the Jumpstart Our Business Startups Act (the “JOBS Act”) to permit companies to offer and sell securities through “crowdfunding.” 1 The SEC also proposed amendments to existing rules under the Securities Act of 1933, as amended (the “Securities Act”) to facilitate intrastate and regional securities offerings. The new rules and proposed amendments aim to assist smaller companies with capital formation and provide investors with additional protections. In a prior memorandum,2 we discussed the key elements of the crowdfunding proposals, which were issued two years ago. Crowdfunding is an evolving method of raising capital that has been used outside of the securities arena to raise funds through the Internet for a multitude of projects. Title III of the JOBS Act created an exemption under the securities laws to permit this type of funding method to be used to offer and sell securities as well. The JOBS Act also established the foundation for a regulatory structure for this funding method. The stated goal of the JOBS Act is to make it easier for start-ups and small businesses to raise funds from a range of potential investors and provide additional investment opportunities for investors. The final rules, Regulation Crowdfunding, among other things, permit individuals to invest in securitiesbased crowdfunding transactions subject to certain investment limits. The rules also limit the amount of money an issuer can raise using the crowdfunding exemption, impose disclosure requirements on issuers for certain information about their business and the securities being offered, and create a regulatory framework for the broker-dealers and funding portals that facilitate the crowdfunding transactions. The full text of the final rules is available at http://www.sec.gov/rules/final/2015/33-9974.pdf. The new crowdfunding rules and forms will be effective 180 days after they are published in the Federal Register. The forms enabling funding portals to register with the SEC will be effective January 29, 2016. 1 For a description of the key elements of crowdfunding, see US$500 and a Click: Investing the “Crowdfunding” Way, Fried Frank Client Memorandum, Stuart H. Gelfond and Anthony D. Foti, June 12, 2012, http://www.friedfrank.com/siteFiles/Publications/6-12-2012%20-%20TOC%20Memo%20-%20Crowdfunding.pdf 2 http://www.friedfrank.com/siteFiles/Publications/FINAL-%20102913%20-%20TOC%20MEMO%20- %20Proposed%20Crowdfunding%20Rules.pdf Fried Frank Client Memorandum 2 The SEC also proposed amendments to existing Securities Act Rule 147 to modernize the rule for intrastate offerings to further facilitate capital formation, including through intrastate crowdfunding provisions. The proposal also would amend Securities Act Rule 504 to increase the aggregate amount of money that may be offered and sold pursuant to the rule from US$1 million to US$5 million and apply bad actor disqualifications to Rule 504 offerings to provide additional investor protection. The full text of the proposed rules is available at http://www.sec.gov/rules/proposed/2015/33-9973.pdf. The SEC is seeking public comment on the proposed rule amendments for a 60-day period following their publication in the Federal Register. Qualifying under Regulation Crowdfunding The final rules impose the following thresholds and limits: Companies are permitted to raise a maximum aggregate amount of US$1 million through crowdfunding offerings in a 12-month period; Individual investors are permitted, over a 12-month period, to invest in the aggregate across all crowdfunding offerings up to: o If either their annual income or net worth is less than US$100,000, than the greater of: US$2,000 or 5 percent of the lesser of their annual income or net worth. o If both their annual income and net worth are equal to or more than US$100,000, 10 percent of the lesser of their annual income or net worth; and During the 12-month period, the aggregate amount of securities sold to an investor through all crowdfunding offerings may not exceed US$100,000. All transactions relying on the new rules would be required to take place through an SEC-registered intermediary, either a broker-dealer or a funding portal. Not all companies will be eligible to utilize the crowdfunding exemption. Excluded companies include nonUS companies, companies with reporting obligations under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), certain investment companies, companies that are subject to disqualification under the disqualification provisions of Regulation Crowdfunding, which exclude certain felons and other bad actors from reliance on the crowdfunding exemption, companies that have failed to comply with the annual reporting requirements under Regulation Crowdfunding during the two years immediately preceding the filing of the offering statement, and companies that have no specific business plan or have indicated that their business plan is to engage in a merger or acquisition with an unidentified company or companies. Also, securities purchased in a crowdfunding offering may not be resold for a period of one year. As a result, lack of liquidity for shareholders may result in some investors having less interest in this market. Holders of these securities would not count toward the thresholds in Section 12(g) of the Exchange Act, which require a company to register with the SEC if a class of securities is held by more than 2000 persons or 500 persons who are not accredited investors, as long as the company is current in its annual Fried Frank Client Memorandum 3 reporting obligations, retains the services of a registered transfer agent and has less than US$25 million in total assets as of the end of its most recently completed fiscal year. Disclosure Requirements for the Issuer under Regulation Crowdfunding The final rules require issuers conducting an offering pursuant to Regulation Crowdfunding to file certain information with the SEC and provide this information to investors and the relevant intermediary facilitating the crowdfunding offering. Among other things, in its offering documents that need to be filed with the SEC, the issuer is required to disclose: a description of the business and the use of proceeds from the offering; the price to the public of the securities or the method for determining the price, the target offering amount, the deadline to reach the target offering amount, and whether the company will accept investments in excess of the target offering amount; related-party transactions between the issuer and any director or officer of the issuer, any person who is a 20 percent beneficial owner (as of the most recent practicable date but no earlier than 120 days prior to the date the offering statement or report is filed), any promoter of the issuer (if the issuer was incorporated or organized within the past three years), or immediate family members of the foregoing persons; information about officers and directors as well as owners of 20 percent or more of the company; a discussion of the company’s financial condition; and financial statements of the company that, depending on the amount offered and sold during a 12- month period, are accompanied by information from the company’s tax returns, reviewed by an independent public accountant, or audited by an independent auditor. A company offering more than US$500,000 but not more than US$1 million of securities relying on these rules for the first time would be permitted to provide reviewed rather than audited financial statements, unless financial statements of the company are available that have been audited by an independent auditor. Companies would be required to amend the offering document to reflect any material changes and provide updates on the company’s progress toward reaching the target offering amount. Also, companies relying on the Regulation Crowdfunding exemption to offer and sell securities would be required to file an annual report with the SEC and provide it to investors to update the previously provided disclosure about the issuer’s contact information; directors, officers and certain beneficial owners; business and business plan; current number of employees; financial condition; ownership and capital structure; material factors that make an investment in the issuer speculative or risky; indebtedness; description of other offerings of securities; and transactions with related parties. Crowdfunding Platforms Crowdfunding transactions must take place through an SEC-registered intermediary, either a brokerdealer or a funding portal. Under Regulation Crowdfunding, the offerings must be conducted exclusively online through a platform operated by a registered broker or a funding portal, which is a new type of SEC Fried Frank Client Memorandum 4 registrant. A funding portal would be required to register with the SEC on new Form Funding Portal, and become a member of a national securities association (currently, FINRA). An issuer relying on the rules would be required to conduct its offering exclusively through one intermediary platform at a time. The final rules require these intermediaries to, among other things: make information available about the issuer and the offering; provide investors with educational materials; take measures to reduce the risk of fraud; provide communication channels to permit discussions about offerings on the platform; facilitate the offer and sale of crowdfunded securities; provide disclosure to investors about the compensation the intermediary receives; accept an investment commitment from an investor only after that investor has opened an account; have a reasonable basis for believing an investor complies with the investment limitations; provide investors notices once they have made investment commitments and confirmations at or before completion of a transaction; comply with maintenance and transmission of funds requirements; and comply with completion, cancellation and reconfirmation of offerings requirements. The final rules prohibit funding portals from: soliciting purchases, sales or offers to buy securities offered or displayed on its platform; offering investment advice or making recommendations; compensating promoters and others for solicitations or based on the sale of securities; and holding, possessing or handling investor funds or securities. The final rules allow an intermediary to receive equity from the companies on its platform as compensation, but do not allow directors, officers or employees of an intermediary to receive equity or any other financial interest from a company on its platform. The final rules provide a safe harbor under which funding portals can engage in certain activities consistent with these restrictions. Proposed Amendments to Securities Act Rule 147 and Rule 504 The proposed amendments would modernize Rule 147 to permit companies to raise money from investors within their state without concurrently registering the offers and sales at the federal level. The proposed amendments to Rule 147 would, among other things: Fried Frank Client Memorandum 5 eliminate the restriction on offers by allowing an issuer to make offers accessible to out-of-state residents, while continuing to require that sales be made only to residents of the issuer’s state or territory; refine what it means to be an intrastate offering by eliminating the limitation of offers to in-state residents only, which raises questions about the proper use of the Internet for these offerings and the limitation of eligible issuers only to those that are incorporated or organized in-state, which excludes local issuers with local operations that incorporate or organize in a different state for business reasons, and ease some of the issuer eligibility requirements in the current rule; and limit the availability of the exemption to offerings that are registered in-state or conducted under an exemption from state law registration that limits the amount of securities an issuer may sell to no more than US$5 million in a 12-month period and imposes an investment limitation on investors. The proposed amendments to Rule 504 of Regulation D would increase the aggregate amount of securities that may be offered and sold under Rule 504 in any 12-month period from US$1 million to US$5 million and disqualify certain bad actors from participation in Rule 504 offerings. The proposed rules would facilitate capital formation and increase investor protection in such offerings. A new era for start-ups seeking to raise capital? The SEC has taken more than three years to consider equity-based crowdfunding after having been called by the JOBS Act in 2012 and included some changes in the final rules to address the concerns of the crowdfunding industry following the proposed rules issued two years ago. The final version of the crowdfunding rules differed in a few key points from the proposed plan, as the SEC responded to concerns of both potential issuers and those worried about less-sophisticated potential investors. One of the major and most anticipated revisions is an exemption from the audit requirements for small first-time crowdfunding issuers. Also, under the final rules, issuers conducting smaller offerings wouldn’t be required to file tax returns, as required under the proposed rules, but instead would be required to disclose specific information from the tax returns. In addition, SEC now also allows issuers to provide required disclosures in a question-and-answer form, rather than more complex and costly legal documentation. Nevertheless, the success of the new rules in helping start-ups to raise capital easily and efficiently is still to be seen. Even though the final rules addressed some of the concerns of issuers, the rules still impose significant restrictions and procedural hurdles for a would-be crowdfunding issuer. Crowdfunding will be costly for issuers, especially compared to other forms of capital raising. An issuer will need to produce an offering disclosure document, enlist a funding portal, run background checks and file an annual report with the SEC. The expenses to be incurred versus the low maximum capital that can be raised by an issuer (and invested by an individual) make crowdfunding a relatively costly form of capital raising.