The SEC recently proposed a regulation to implement the exemption from Securities Act registration for “crowdfunding” securities offerings that was dictated by the Jumpstart Our Business Startups Act (JOBS Act). Crowdfunding is a funding method used by startups and other small businesses to raise limited amounts of capital from individuals through the Internet. “Regulation Crowdfunding” would provide the framework for these firms to move beyond obtaining funds through donations or advance purchases of finished products to soliciting individuals to invest in the securities of their enterprises. Eligible issuers could raise up to $1 million during a 12-month period under the regulation through the offer and sale of securities made through a registered broker or a “funding portal” acting as an intermediary between the issuer and prospective investors. Offers and sales of securities under the proposed regulation would remain subject to the antifraud provisions of the securities laws and to state registration and offering requirements.

The SEC proposed the new regulation in a 585-page release (No. 33-9470), which is available here. Comments on the proposal are due by February 3, 2014.

Issuer requirements and limitations

The terms of the proposed regulation hew closely to the mandate of Title III of the JOBS Act. In addition to requiring eligible issuers to conduct their crowdfunding offerings through an intermediary, the new regulation would restrict their promotional efforts, require them to issue an offering statement, and obligate them to publish an annual report. These requirements are intended to safeguard investors while providing a mechanism through the intermediary’s platform to make the offering accessible to a wide range of investors and to enable investors to share their information and opinions about the issuer and its offering. The evaluation of potential investments is expected to benefit from the “wisdom of crowds” expressed through the aggregation of individual viewpoints, which is the basis of the crowdfunding process. Insignificant deviations from the regulation would not be a basis for denying the exemption to an issuer that exhibits good faith and a reasonable effort to comply.

Ineligible issuers. The following issuers would not be eligible to raise funds under the new regulation:

  • Non-U.S. companies
  • Companies that file reports under the Exchange Act
  • Investment companies
  • Certain investment funds excluded from the definition of “investment company”
  • Companies disqualified under the proposed standards
  • Companies that previously made a crowdfunding offering but did not file satisfactory annual reports
  • Companies that have no business plan or that have indicated their business plan is to engage in a merger or acquisition with an unidentified company or companies

Use of intermediary’s platform. Crowdfunding transactions would have to be conducted through the electronic platform of the intermediary.

Advertising. Although an issuer could not advertise a crowdfunding offering, it could direct investors to the intermediary’s platform and discuss with investors the terms of the offering through channels provided by the intermediary.

Promoter compensation. An issuer could compensate a person to promote its crowdfunding offering if the promoter engages in its promotional efforts through the intermediary’s platform and discloses the receipt of its compensation in every promotional communication.

Disclosure requirements. The issuer would be required to file with the SEC and provide investors and the intermediary an offering statement containing the following information about the issuer and the offering:

  • Issuer’s name, address, website and principal business
  • Board members, officers and 20% owners
  • Risk factors that make the offering speculative
  • Targeted amount of offering proceeds, deadline for meeting the target, the issuer’s commitment to return all proceeds if the target is not met by the specified deadline, and updates at specified intervals of the issuer’s progress in achieving its target
  • Number, price and other terms of securities being offered, and purpose and use of offering proceeds
  • Amount of compensation paid to the intermediary
  • Certain related-party transactions
  • Financial data concerning the issuer, which would consist of (a) audited financial statements for offerings of more than $500,000, (b) financial statements reviewed by an independent public accountant for offerings of more than $100,000 up to $500,000 and (c) financial statements certified by the principal executive officer as true and complete in all material respects, and any income tax returns for the most recently completed year, for offerings of $100,000 or less

Ongoing reporting requirements. The issuer would have to file with the SEC and post on its website an annual report of its results of operations and other specified matters until:

  • The issuer becomes a reporting company under Section 13(a) or 15(d) of the Exchange Act;
  • The issuer or another party repurchases all of the securities issued in the crowdfunding offering; or
  • The issuer liquidates or dissolves its business in accordance with state law.

Investor requirements and limitations

To reduce the risk of loss by investors in a crowdfunding offering and conform to JOBS Act requirements regarding resales of the offered securities, the new regulation would limit the amount a person could invest individually, require that each investor be furnished with specified information, provide cancellation rights to investors, and restrict transfers during the year following the purchase of securities in the offering.

Investment limits. Investors would be restricted in the amount of securities they could purchase in a 12-month period based on the annual income or net worth of the person and the person’s spouse:

  • An investor with both income and net worth of less than $100,000 could purchase securities with a value up to the greater of $2,000 or 5% of the investor’s annual income or net worth
  • An investor with income or net worth of at least $100,000 could purchase securities with a value up to 10% of the investor's annual income or net worth, not to exceed $100,000 in the 12-month period

Account opening. An investor would have to open an account with the intermediary and receive specified information about the offering and educational materials explaining the offering process and applicable restrictions and limitations.

Cancellation rights. An investor would have an unconditional right to cancel an investment commitment within 48 hours after making it, subject to the exception that a cancellation during the final 48 hours of the offering would be permitted only if there were a material change to the offering terms or to other information provided by the issuer regarding the offering.

Resale restrictions. An investor could not transfer securities purchased in a crowdfunding offering for one year after purchase, except to the issuer, an accredited investor, a buyer in a registered resale offering or a family member, or in connection with the investor’s death or divorce. Holders of the securities would not count toward the threshold that requires an issuer to register a class of equity security under Section 12(g) of the Exchange Act.

Intermediary requirements and restrictions

The new regulation would require that an issuer’s crowdfunding transaction be conducted online through a single intermediary, in order to foster the creation of a “crowd” for the sharing of information and the evaluation of the idea or business that is the basis of the crowdfunding effort. The offering would have to be made through the intermediary’s electronic platform on the Internet or other similar electronic medium because offerings through non-electronic means would be inconsistent with the underlying principles of crowdfunding.

Intermediary qualifications. A person acting as an intermediary in a crowdfunding offering would have to:

  • Register with the SEC as either a broker or a new type of SEC registrant called a “funding portal”
  • Be a member of the Financial Industry Regulatory Authority (FINRA) or any other registered national securities association
  • Not have a financial interest in the issuer’s offering or receive such an interest as compensation for its services in the offering
  • Prohibit its associated persons (its directors, officers or persons performing similar functions) from having a financial interest in the issuer

Funding portal restrictions. A funding portal could act as an intermediary without registering with the SEC as a broker, but neither it nor its associated persons could:

  • Offer investment advice or recommendations
  • Solicit purchases, sales or offers to buy the securities displayed on its platform
  • Compensate parties for solicitation efforts or sales of securities displayed or referenced on its platform
  • Hold, manage, possess or otherwise handle investor funds or securities
  • Engage in other activities that the SEC determines by rule to be inappropriate

The proposed regulation would provide a safe harbor under which funding portals could engage in certain activities consistent with these restrictions.

Duties of intermediaries. Among its numerous duties, an intermediary would have to:

  • Make the requisite offering information publicly available on its platform for 21 days before any sales are made
  • Establish a reasonable belief that prospective investors will satisfy applicable investor limitations
  • Provide communications channels on its platform for persons to communicate with one another and with issuer representatives regarding offerings available on the platform
  • Furnish to a person who has made an investment commitment a written notification of the commitment
  • Conform to specified procedures for the maintenance and transmission of funds
  • Provide each investor in the offering with a written confirmation of the investment
  • Advise investors of material changes to the terms of the offering or the information provided by the issuer and indicate to each investor who has made an investment commitment that the commitment will be canceled unless the investor reconfirms the commitment within five business days
  • Notify investors within five business days of a determination not to complete an offering, the reason for the determination, and the amount of the refund the investor is expected to receive

Fraud prevention. An intermediary would have to:

  • Reasonably believe that the issuer makes available to the SEC, prospective investors and the intermediary specified information regarding the offering
  • Reasonably believe that the issuer has established a means for keeping accurate records of the holders of securities acquired through the intermediary’s platform
  • Deny access to its platform if it has reason to believe that (a) the disqualification provisions of the regulation would apply to the issuer or any of its officers, directors or 20% holders or (b) the issuer or the offering raise concerns about potential fraud or investor protection

Commentary

The complexity of the crowdfunding proposal was unavoidable because the extensive standards of the exemption were dictated by the JOBS Act and the SEC wanted to explore all possibilities for achieving workable requirements for implementing them. This approach is reflected in the 284 questions raised in the release requesting comment on possible alternative approaches.

It is unclear how useful the crowdfunding method of raising capital will be to the entrepreneurs and small businesses that are expected to use it. Some features of the proposed scheme, particularly the requirements for the preparation of an offering document and periodic reports after the offering, are likely to compel most potential users to seek costly professional help and pay sizable fees to intermediaries to satisfy the requirements of the exemption. One commentator has expressed the view that the expenses might be as much as $100,000, making crowdfunding “the worst ‘bang for your buck’ in all of corporate finance.” Although the SEC is aware of this concern and can be expected to seek all reasonable means to soften the impact of the requirements after considering public comments on the proposal, its ability to make meaningful changes will be limited by the provisions of the JOBS Act.

Regulators and other interested parties have expressed concern that the crowdfunding exemption will be misused to defraud unsophisticated small investors. To address this concern, the SEC has built into the proposal the concept of intermediaries that will serve as guardians against fraud. Major investment banking firms, however, have indicated a lack of interest in expending their resources on the operation and oversight of small crowdfunding offerings, so it is likely that most intermediaries will be small firms that have limited experience and resources to fulfill their responsibilities. It remains to be seen how effective they might be in preventing fraud and performing their administrative functions.