On October 30, 2015, the Securities and Exchange Commission published its long-awaited rules under Title III of the Jumpstart Our Business Startups (JOBS) Act. According to the nearly 700-page adopting release, “Regulation Crowdfunding” will permit companies to offer and sell securities through Internet-based fundraising techniques known generally as crowdfunding. Although offers and sales of securities pursuant to Regulation Crowdfunding will be subject to a number of significant requirements and limitations, they will not be subject to many of the limitations imposed on other exempt offerings, such as the general solicitation restriction of Securities Act Rule 506(b) or the accredited investor requirements of Securities Act Rule 506(c).
While crowdfunding has been used in many contexts to raise money via the Internet, companies generally have been prevented from using this technique to offer and sell securities because such activities trigger the federal securities laws, including those generally requiring the offer or sale of securities to be registered unless a specific exemption is available, and those generally requiring persons or entities intermediating such offers and sales to register as broker-dealers. Title III of the JOBS Act created a federal exemption under the securities laws to facilitate this type of fundraising for small, emerging companies that included an exemption from the registration requirements of the Securities Act to permit securities-based crowdfunding, and created a new form of intermediary, a “funding portal,” that will be permitted to facilitate such offers and sales without registration under the Exchange Act as a broker-dealer (although broker-dealers also will be able to engage in crowdfunding transactions).
According to the SEC, Regulation Crowdfunding was designed to facilitate capital formation by emerging companies while still providing investors with necessary protections. It allows investments in securities via crowdfunding transactions, but limits the amount of money an issuer can raise using this method. It permits individual investors to participate, but limits how much they can invest. It permits companies offering securities in reliance on Regulation Crowdfunding to concurrently effect other exempt offerings, provided that each offering fully complies with the requirements of the applicable exemption (for example, an issuer conducting a concurrent exempt offering for which general solicitation is not permitted will need to confirm that purchasers in that offering were not solicited through the Regulation Crowdfunding offering). Securities purchased through crowdfunding generally will be restricted from resale for one year.
Transactions relying on the new rules will be required to take place through a broker-dealer or funding portal. Like broker-dealers, funding portals will be required to register with the SEC and become members of FINRA. Such intermediaries will be required, among other things, to provide investors with educational materials and information about companies offering securities. They will have to take steps to reduce the risk of fraud and will be prohibited from having a financial interest in the companies that offer or sell securities on their platforms unless received as compensation for their services. Because the activities of funding portals are intended to be more limited than those of registered broker-dealers, they will be prohibited from offering investment advice or making recommendations; soliciting purchases, sales or offers to buy securities; compensating promoters and others for soliciting purchases and/or compensating them based on the sale of securities; and handling or holding investor funds or securities.
Although Regulation Crowdfunding will not become effective until 180 days after the final rules are published in the Federal Register, already the SEC is being criticized for the regulation being too limited, for investment restrictions that are too restrictive, and for continuing to deny “ordinary people” (i.e., the “non-rich”) the opportunity to invest in the “next big thing.” Some have complained that the information requirements are too strict and compliance will be too costly. Others have suggested that the only companies that will try to sell securities pursuant to Regulation Crowdfunding are those in which no one will want to invest. A lot of these critics fail to realize that the limitations in the new regulation are faithful to and consistent with the JOBS Act provisions on which they are based.
Sifting through the new regulation and the voluminous adopting release, it is apparent that the SEC is being extremely cautious as it dips its toe into the crowdfunding water. The limitations and restrictions on companies, investors and intermediaries are obvious and significant. But, after all, the Internet can be a bit of a scary and dangerous place. The same miraculous technology that now gives small start-up companies the ability to reach millions of investors also enables fraudsters to reach millions of potential victims and hide from the authorities charged with stopping them. Indeed, just this week the SEC brought charges against a stock trader who allegedly used what looked like real Twitter accounts of well-known securities research firms to disseminate false tweets to manipulate stock prices.
While it sometimes may be hard to sympathize with a federal regulator, one has to remember that the first item in the SEC’s mission statement is “to protect investors.” Having endured withering criticism for failing to prevent the market collapse of 2008, the Madoff fraud, the flash crash and scores of other negative market events, it is understandable that the SEC would proceed slowly and cautiously when allowing the vastness of the Internet to be used to offer securities of small companies with few assets, little if any track record, and not much more than an optimistic business plan. Let’s face it, as the unsuccessful ones start collapsing, and small investors start losing what, for them, are significant amounts, is there really any likelihood that the injured investors won’t be complaining that the SEC failed in its mission and did not protect them adequately?
As with any new venture, a reasonable assessment of Regulation Crowdfunding is a long way off. Its value can only be judged through experience—and that will take time.