The Securities and Exchange Commission ("SEC") proposed for comment new regulations on Crowdfunding.
Crowdfunding is the general term used to describe a new way of raising capital using the Internet. A crowdfunding campaign generally has a specified target amount of money to be raised, an identified use of those funds, and is often associated with small investments from a large group of people. Until now, crowdfunding websites did not facilitate the sale of securities.
The Jumpstart Our Business Startups Act ("JOBS Act"), enacted on April 5, 2012, created a regulatory framework which permits, upon the adoption of these rules by the SEC, individuals and companies to sell securities to the public using crowdfunding. (It should be noted that these rules do not apply to "crowdfunding" websites that sell securities but limit the investors to "accredited investors.")
The JOBS Act established a new exemption under the Securities Act of 1933 under Section 4(a)(6). These proposed regulations would provide additional requirements that both issuers and companies that are seeking to engage in the crowdfunding business as an intermediary would need to meet.
Below we summarize and discuss the proposed rules applicable to issuers that, in our view warrant particular attention. Part 2, to be addressed in our next alert, discusses the proposed rules applicable to the crowdfunding intermediaries, as well as the proposed rules relating to the liability scheme.
As a general matter, the SEC has proposed rules that are often difficult and technical in nature. The disclosure obligations include items such as financial statements (which must be audited if the issuer is raising over $500,000, certified by an independent public accountant, if the issuer is raising between $100,000 and $500,000), a written summary of the issuer's financial conditions, such as one would find in a Management Discussion and Analysis section of a prospectus, and a discussion of the material factors that make an investment in the issuer speculative or risky.
In addition, reliance on this exemption obligates the issuer to provide ongoing annual reports to its shareholders, in many cases forever. These annual reports would mirror the offering statement, including the narratives discussed above, and in many cases would require audited financial statements on a yearly basis.
The proposed rules do permit the intermediary to provide advice in complying with the rules (whether this constitutes providing legal advice under state law is another matter). However, the SEC is not proposing a form to assist the issuers, or even providing a general outline of some of the required disclosures. This makes it very difficult for the average company to meets its legal obligations under Section 4(a)(6) and these proposed regulations.
The complexity of these rules all but requires companies to utilize substantial legal assistance in connection with their offerings. This requires these small companies to use their limited resources, not on product development, research or other potentially value creating activities, but on accountants and lawyers. To make matters more difficult, the regulatory liability scheme for crowdfunding offerings can leave directors, officers, and other employees involved in the offering with personal liability despite acting on behalf of the entity.
Despite the supposed good intentions, crowdfunding under Section 4(a)(6), as currently proposed, does not appear ready to help small businesses close the funding gap. In this author's view, the proposed rules should be designed to foster an open and transparent market, with a few limited, but clear rules regarding disclosures. Strong civil and criminal liability, as exists under the current statute, would protect investors from fraudulent activity. The twin stated goals of investor protection and capital formation would be better served by truly relying upon the "wisdom of the crowd" instead of re-creating the obligations under a registration statement, through rules that require 568 pages to propose (that is not a typo).
These rules are proposed, and have not yet been adopted. Until rules have been adopted, the Section 4(a)(6) exemption is not yet available.
If you do not agree with the SEC's proposed rules or have any other thoughts or comments on them, please send them to the SEC. Comments should be received by the SEC on or before February 3, 2014.
The JOBS Act enacted a new exemption for the offer and sale of securities pursuant to Section 4(a)(6) of the Securities Act of 1933 (the "Securities Act"), which provides for an exemption from the registration requirements of the Securities Act of Section 5 for certain transactions.
To qualify for this exemption, transactions by an issuer must meet certain specified requirements, including:
- The amount raised in all Section 4(a)(6) offerings must not exceed $1 million in a 12-month period;
- Each investor is limited to an agreement amount of investments under Section 4(a)(6) of either;
- The greater of $2,000 or 5 percent of annual income or net worth, if annual income or net worth of the investor is less than $100,000; and
- 10 percent of annual income or net worth (not to exceed an amount sold of $100,000), if annual income or net worth of the investor is $100,000 or more; and
- The transaction must be conducted through an intermediary that is either registered as a broker or is registered as a new type of entity, called a "funding portal;"
- The issuer must provide certain information to investors and potential investors, take certain other actions and provide notices and other information to the Commission;
The JOBS Act required the SEC to propose certain rules regarding the implementation of these provisions, as well rules that would implement exemptions from the Securities Exchange Act of 1934 (the "Exchange Act").
Limitation on Capital Raised under Section 4(a)(6)
As discussed above, Section 4(a)(6) provides that "the aggregate amount sold to all investors by the issuer, including any amount sold in reliance on the exemption provided under [Section 4(a)(6)] during a 12-month period preceding the date of such transaction is not more than $1,000,000.
- The proposed rules clarify that only capital raised under Section 4(a)(6) is counted toward the limitation. Capital raised through other means would not be counted in determining the aggregate amount sold in reliance on Section 4(a)(6)
- The proposed rules also permit an issuer to complete an crowdfunding transaction under Section 4(a)(6), simultaneously with, proceeded by, or following, another exempt offering. The proposed rules add some limitations, particularly in the case of an exempt offering for which general solicitations is permitted.
- In determining the 1,000,000 aggregate amount limitation, an issuer is required to aggregate its sales with all sales under Section 4(a)(6) made by all entities that are controlled by or under common control with the issuer, as well as any predecessors of the issuer.
- The SEC is proposing to use the same definition of "control" that is set forth in Rule 405, which is "the power to direct or cause the direction of the management and policies of a person, whether through the ownership of voting securities by contract, or otherwise." Generally the SEC views officers, directors, and certain large shareholders as generally having control. The use of this definition may cause problems for issuers, particularly in the technology space with certain angel investors, and directors, having roles at multiple companies. If enacted as proposed, companies will need to be extremely careful of the calculation of this limitation.
As indicated above, Section 4(a)(6) limits the amount of securities that any individual can purchase annually. The limits are based upon the income or assets of the purchaser.
The proposed rules:
- Clarify that there is an overall investment limit of $100,000 per year.
- Clarify that annual income and net worth may be calculated jointly with the annual income and net worth of the investor's spouse.
- Permit the issuer to rely upon the efforts that intermediary take in order to determine that the aggregate amount of securities purchased by an investor will not cause the investor to exceed the investor limits, provided that the issuer does not have knowledge that the investors had exceeded, or would exceed, the investor limits as a result of purchasing in the offering.
Use of Crowdfunding Intermediary
Under Section 4(a)(6), a transaction made in reliance on the exemption, "must be conducted through a broker or funding portal that complies with the requirements of Section 4A(a)."
The proposed rules:
- Require an issuer to use only one intermediary, rather than allowing the issuer to use multiple intermediary, to conduct an offering or concurrent offerings in reliance on Section 4(a)(6).
- Require that the offering be effected exclusively through the intermediary's internet website or other similar electronic medium. A intermediary may, however, perform certain back office and other administrative functions offline.
- Require that the intermediary, in its standard account opening materials, obtain from the investors consent for electronic delivery of all documents and other information in connection with the offering.
Exclusion of Certain Issuers from Eligibility under Section 4(a)(6)
Section 4A(f) of the Securities Act excludes certain categories of issuers from eligibility to rely upon Section 4(a)(6) to engage in exempt crowdfunding exemptions. These are (1) foreign issuers (2) issuers that are subject to Exchange Act reporting requirements (generally public companies); (3) investment companies, or companies that are excluded from the definition of investment company under Section 3(b) or 3(c) of the Investment Company Act.
The proposed rules also exclude the following:
- Issuers that are subject to the "bad-boy" disqualifications provisions under Section 302(d) of the JOBS Act;
- Issuers that had previously sold securities in reliance on Section 4(a)(6) and that have not filed with the SEC and provided to investors, to the extent required, the ongoing annual reports proposed to be required under these regulations (the annual reporting requirement is discussed below); and
- Issuers that have no specific business plan, or has indicated that its business plan is to engage in a merger or acquisition with an unidentified company or companies.
Disclosure Requirements for Issuers
Section 4A(b)(1) provides that an issuer offering or selling securities in reliance on Section 4(a)(6) must file certain specified disclosures, including financial disclosures, with the SEC, provide these disclosures to investors and the relevant broker or funding portal and make these disclosures available to potential investors.
The disclosures set forth in Section 4A include items such as
- the names of the directors and officers of the issuer, and each person holding more than 20 percent of the shares of the issuer;
- a description of the business of the issuer and the anticipated business plan of the issuer;
- a description of the financial condition of the issuer (which requires that issuer's offering more than $500,000 file with the Commission, provide to investors and the intermediary, and make available to potential investors audited financial statements).
- a description of the stated purpose and intended use of the proceeds of the offering sought by the issuer with respect to the target offering amount;
- the target offering amount;
- the deadline to reach the target offering amount and regular updates regarding the progress of the issuer in meeting the target offering amount;
- the price to the public of the severities or the method for determining the price; and
- a description of the ownership and capital structure of the issuer.
In addition to these statutory requirements, the proposed rules:
- require the issuer to provide a discussion of the material factors that make an investment in the issuer speculative or risky;
- require a narrative discussion of the issuer's financial condition. This discussion will need to address, to the extent material, the issuer's historical results of operations in addition to its liquidly and capital resources. If an issuer does not have a prior operating history, the discussion should focus on financial milestones and operational, liquidity and other challenges. If an issuer has a prior operating history, the discussion should focus on whether historical earnings and cash flows are representative of what investors should expect in the future;
- mandate specific disclosures related to ownership and capital structure, such as a detailed explanation of the terms of the securities being offered and each other class of security of the issuer, a description of how the exercise of the rights held by the principal shareholders of the issuers could affect the purchasers, and how the securities being offered are being valued, and examples of methods for how such securities may be valued by the issuer in the future;
- require the issuer to identify whether the issuer will accept investments in excess of the target offering amount;
- do not specify which disclosures are required in the description of the business and the business plan;
- require the disclosure of the amount of compensation paid to the intermediary for conducting the offering;
- require a discussion of the material factors that make an investment in the issuer speculative or risky;
- require disclosure of the material terms of any indebtedness of the issuer,
- disclosure related to exempt offerings conducted within the last three years;
- disclosure of certain related party transactions; and
- require that these disclosures be filed with the SEC on EDGAR in the XML format using a XML fillable form.
Progress Updates and Amendments
The proposed rules would require an issuer to prepare regular updates on its progress in meeting the target offering amount – currently at one-half and one hundred percent of the target offering amount. These updates would also need to be filed with the SEC on EDGAR.
The proposed rules also require a filing of a final progress update, no later than five business days after the offering deadline, disclosing the total mount of securities sold in the offering.
The proposed rules also require that any material changes in the offer terms or other disclosures must be filed with the SEC via EDGAR.
Ongoing Reporting Requirements
Section 4A requires that an issuer that has raised capital using the Section 4(a)(6) exemption must file with the SEC and provide to investors reports of the results of operations and financial statements of the Issuer not less than annually.
The proposed rules:
- require that the issuer post the annual report on their website.
- require that these reports disclose information similar to the information required in the offering, including disclosure about its financial condition that meets the financial statement requirements applicable in the offering state. In many cases, this will require that the financial statements be audited.
- The rules would require the issuer to continue filing these reports until (1) the issuer becomes a report company required to file reports under the Exchange Act Sections 13(a) or 15(d) (2) the issuer or another party purchases or repurchases all of the securities issued pursuant to Section 4(a)(6), including any payment in full of debt securities or any complete redemption of redeemable securities or (3) the issuer liquidates or dissolves its business in accordance with state law.
Prohibition on Advertising Terms of the Offering
Section 4A(b)(2) provides that an issuer shall "not advertise the terms of the offering, except for notices which direct investors to the funding portal or broker."
The proposed rules:
- Provide that an issuer can publish a notice advertising the terms of the offering in reliance on Section 4(a)(6), provided that the notice includes the address of the intermediary's platform on which additional information about the issuer and the offering may be found;
- State that the notice advertising may include no more than the following:
- a statement that the issuer is conducting an offering, the name of the intermediary through which the offering is being conducted, and a link directing the potential investor to the intermediary's platform,
- the terms of the offering ("terms of the offering" would include (1) the amount of securities offered, (2) the nature of the securities offered, (3) the price of the securities, and (4) the closing date of the offering period.); and
- factual information about the legal identity and business location of the issuer, limited to the name of the issuer of the security, the address, phone number and website of the issuer, the e-mail address of a representative of the issuer and a brief description of the business of the issuer.
- There are no limitations in the proposed rules on how these advertisements may be distributed;
- Issuers may only communicate with investors and potential investors about the terms of the offering through specified "communication channels" hosted on the intermediaries website.