The Securities and Exchange Commission ("SEC") voted 5-0 on October 23, 2013 to approve the proposed crowdfunding rules required by Title III of the Jumpstart our Business Startups Act of 2012 (the "JOBS Act"). The rules will govern the offer and sale of securities under the new Section 4(a)(6) of the Securities Act of 1933 (the "Securities Act") and are subject to a 90 day comment period. The proposed rules could be finalized by the SEC as early as February 2014.
Crowdfunding is a relatively new method of raising capital from individuals. It allows a company to raise capital from individuals that are not accredited investors without the requirements of a registered or public offering. Crowdfunding is especially useful for funding projects, causes or startup companies and has increased in popularity in recent years due largely to the expanded use of social media by investors and companies. The proposed rules provide an exemption from registration requirements under the Securities Act, effectively expanding the use of crowdfunding from a primarily donation-based system to a capital investment system.
Although the proposed rules are a welcome development for companies seeking to raise money online by offering equity to a wide range of individuals (including non-accredited investors), they impose many conditions that companies must consider. These conditions mitigate the potential for fraud in the sale of illiquid crowdfunding securities to retail investors. The proposed rules:
- set forth eligibility criteria for the exemption;
- place limits on the investment capital of the company;
- regulate the intermediaries necessary to conduct crowdfunding transactions;
- require companies to provide detailed disclosures to the SEC; and
- restrict the advertising and transfer of crowdfunding securities.
The exemption from the registration requirements of Section 5 of the Securities Act pursuant to the crowdfunding exemption in new Section 4(a)(6) is not available to companies that:
- are subject to the reporting requirements of the Securities and Exchange Act of 1934;
- are investment companies (including certain funds that are excluded from the definition of "investment company" under the Investment Company Act of 1940);
- are organized outside of the U.S.;
- are not in compliance with the annual reporting requirements of the proposed rules during the immediately preceding two years; or
- do not have a business plan or whose business plan is to enter into a business combination with as-yet unidentified targets.
Limits on Investment Capital
The proposed rules set forth certain limitations on both the total amount of money raised through the exemption and the amount of money raised from each investor. Although the proposed rules do not limit the number of investors in a crowdfunding offering, the amount of money a company raises through the exemption is subject to the following limitations:
- the company may not raise more than $1 million in the preceding twelve month period in reliance upon the crowdfunding exemption (it may raise additional funds through any other offering that relies on a different exemption such as Regulation D or Regulation S);
the total amount sold to any investor during the preceding twelve month period in reliance upon the crowdfunding exemption may not exceed:
- the greater of $2,000 or 5% of the annual income or net worth of the investor, if either the annual income or the net worth of the investor is less than $100,000; or
- 10% of the annual income or net worth of an investor (not to exceed a maximum total amount sold of $100,000), if either the annual income or net worth of the investor is $100,000 or more.
Regulation of Intermediaries
An exempt crowdfunding offering must be conducted entirely online through a broker or "funding portal," both of which must be FINRA-registered. Section 3(a)(80) of the Securities Act, as added by Section 304 of the JOBS Act, defines "funding portal" as any person acting as an intermediary in a transaction involving the offer or sale of securities for the account of others, solely pursuant to Section 4(a)(6) of the Securities Act, subject to the conditions set forth below:
The broker or funding portal intermediary is barred from:
- owning any of the company's securities
- offering investment advice or making recommendations regarding the company's securities; and
- compensating employees, agents or other persons for solicitation.
The broker or funding portal intermediary is required to:
- have a reasonable basis for believing that the crowdfunding company is in compliance with the applicable crowdfunding rules;
- provide investors with information about the company and the offering, including material describing the risks associated with investing in the securities, the circumstances in which the company may cancel an investment commitment and the limitations on an investor's right to cancel an investment commitment;
- enact measures to deter fraud, particularly where the offering of securities in a company raises specific concerns regarding investor protection (the "gatekeeper" role); and
- provide channels for communication regarding the crowdfunding offering.
Companies offering equity through crowdfunding are required to prepare a comprehensive offering statement. This offering statement must be filed with the SEC no later than 21 days before the first sale and must be provided to the company's intermediary and made available to investors. The report must be posted on the company's website and must contain annually updated financial statements and updates to any information already disclosed by the company. This ongoing reporting obligation ceases only when the company becomes a reporting public company, when the company liquidates or dissolves or when all of the crowdfunding securities that were initially offered are repurchased. The offering statement must disclose, among other things, the following:
- information about directors, officers and owners of 20% or more of the company's equity;
- a description of the company's business plan and the use of offering proceeds;
- the price of the security being offered and how the valuation of the securities was determined;
- the target offering amount;
- information regarding related-party transactions;
- financial statements that must be certified by the company's chief financial officer if the company's offering is less than $500,000 in the preceding twelve month period and must be audited if the company's offering is $500,000 or above in the preceding twelve month period; and
- risk factors in purchasing the crowdfunding securities.
Limitation on Solicitation
The recent lifting of the prohibition of general solicitation in certain private offerings pursuant to the JOBS Act (as more fully discussed in our July Corporate Alert, allowed private companies to market directly to investors considered sophisticated and wealthy enough to understand the risks of investing and to be able to endure a financial loss. Crowdfunding, on the other hand, is open to virtually any investor regardless of income or net worth, triggering a greater concern for investor protection. Therefore, unlike private placements in which issuers are permitted to generally solicit under Rule 506 of Regulation D, crowdfunding securities may not be generally advertised to the public under the proposed rules. Rather, the offering of crowdfunding securities may only be targeted to direct investors through the company's intermediary.
Limitations on Transfer
Securities purchased in a crowdfunding transaction are subject to a one-year resale restriction. During this time period, transfers of the securities can be made only to family members, accredited investors or the company itself, or in a registered transaction.
Implications for Registration and Liability
Holders of crowdfunding securities do not count towards the holder threshold for issuer registration under Section 12(g) of the Securities Act.
Consistent with Sections 12 and 13 of the Securities Act, purchasers of crowdfunding securities can pursue a rescission remedy if the company makes a material misstatement or omission in connection with a sale.