United States: SEC Proposes Rules On Crowdfunding

On October 23, 2013, the Securities and Exchange Commission (SEC) proposed rules which would, if adopted, govern the offer and sale of securities under new Section 4(a)(6) (the "Crowdfunding Exemption") of the Securities Act of 1933 (Securities Act), provide a framework for the regulation of registered funding portals and brokers, and exempt securities sold pursuant to the Crowdfunding Exemption from the registration requirements of Section 12(g) of the Securities Exchange Act of 1934 (Exchange Act).

On April 5, 2012, President Obama signed the Jumpstart Our Business Startups (JOBS) Act into law. The JOBS Act seeks to reduce securities law burdens on start-ups and on small businesses to make capital more accessible. In enacting the JOBS Act, Congress requires the SEC to implement rules that grant cost-effective access to capital for companies of all sizes in the form of capital formation, disclosure, and registration requirements.

Title III of the JOBS Act amends Section 4 of the Securities Act to create an exemption for crowdfunding activities. Crowdfunding is a term used to describe a network of people who pool their money, usually via the Internet, to collectively support the financing needs of another person or organization. Under Title III, crowdfunding will be exempt from securities registration subject to the following conditions:

  • The aggregate amount sold to all investors by the issuer, including any amount sold in reliance on the crowdfunding exemption during the 12-month period preceding the date of the transaction is not more than $1 million;
  • The aggregate amount sold to any investor by the issuer, including any amount sold in reliance on the crowdfunding exemption during the 12-month period preceding the date of the transaction, does not exceed: (1) the greater of $2,000 or five percent of the annual income or net worth of the investor, as applicable, if either the annual income or the net worth of the investor is less than $100,000; or (2) 10 percent of the annual income or net worth of an investor, as applicable, not to exceed a maximum aggregate amount sold of $100,000, if either the annual income or net worth of the investor is equal to or more than $100,000;
  • The transaction is conducted through a registered broker or funding portal that complies with the requirements of the exemption; and
  • The issuer complies with the disclosure requirements of the exemption.

Summary of the Proposed Crowdfunding Regulations

The proposed regulations, if enacted as approved, can be broken down as follows: (1) crowdfunding exemption; (2) requirements on issuers; (3) requirements on intermediaries; (4) additional requirements of funding portals; and (5) miscellaneous provisions.

Crowdfunding Exemption

The Crowdfunding Exemption places a limitation on the amount of capital that may be raised by an issuer. The proposed rules clarify these limitations by stating that only capital raised in reliance on the Crowdfunding Exemption apply to the $1 million annual limitation, while capital raised through other means, including other exemptions, will not be counted toward the $1 million cap. An issuer who engages in Crowdfunding Exemption offerings may draw scrutiny by the SEC for:

  • Simultaneous offers in which only one offering allows for general solicitation;
  • Securities sold by entities controlled by or under common control with the issuer as securities sold by controlled entities will be considered sold by the issuer themselves.
  • Securities sold by a predecessor of the issuer during the preceding 12-months as securities sold by the issuer's predecessor will be considered aggregated in enforcing the $1 million cap.

The JOBS Act excludes the following issuers from utilizing the Crowdfunding Exemption: (1) issuers not organized under the laws of a state or territory of the United States; (2) issuers that are subject to Exchange Act reporting requirements; (3) investment companies as defined in the Investment Company Act of 1940; and (4) any other issuer that the SEC deems appropriate. The SEC proposes to also exclude, by rule, the following issuers:

  • Those disqualified under the provisions of Section 302(d) of the JOBS Act;
  • Issuers who have failed to file and provide to investors ongoing annual reports for the two years immediately preceding the filing of the new offering statement; and
  • Issuers who 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.

A single transaction in reliance on the Crowdfunding Exemption will need to be conducted through only one broker or funding portal using either an Internet website or other similar electronic medium. Additionally, the proposed rules outline an online-only platform which enables the public to access offering information and share information publicly; the effect being that such transactions will be exclusively conducted through an intermediary's platform.

Requirements on Issuers

As mandated by the JOBS Act, an issuer must disclose to prospective investors, among other things, the business experience of directors and officers, the name of any person who controls 20% of more of the issuer's voting power, the target offering amount, its deadline and whether the issuer would accept investments in excess of the target amount, cancellation procedures in the event of a material change, and the number and description of securities being offered. The proposed rules also prescribe additional disclosure requirements regarding the issuer and the offering which include:

  • The material factors that make an investment in the issuer speculative or risky;
  • The material terms of any indebtedness of the issuer, including the amount, interest rate, maturity date and any other material terms;
  • The disclosure of exempt offerings conducted within the past three years; and
  • The disclosure of certain related-party transactions (those between the issuer and any director or officer of the issuer, any person who is a 20% beneficial owner, any promoter of the issuer, or immediate family members of the foregoing persons).

In addition to issuer and offering disclosures, the proposed rules add additional financial disclosures for issuers. Although many of the issuers seeking to rely on the Crowdfunding Exemption will not have an operating history, all issuers must prepare financial disclosures for investors in accordance with U.S. generally accepted accounting principles, covering the shorter of the two most recently completed fiscal years or the period since inception of the business.

All issuers, even those with no more than a business plan, must comply with the proposed rules as follows:

  • The first tier, aggregate offerings of $100,000 or less, are required to provide previous income tax returns. The proposed rules allow for the redaction of personally identifiable information;
  • The second tier, aggregate offerings of more than $100,000 but not more than $500,000, are required to provide financial statements reviewed by an independent public accountant. The proposed rules provide for the financial statements to be reviewed in accordance with the Statements on Standards for Accounting and Review Services; and
  • The third tier, aggregate offerings of more than $500,000, are required to provide audited financial statements. The proposed rules state that an issuer that receives an unqualified or a qualified audit opinion would be in compliance, but an issuer that receives an adverse opinion or a disclaimer of opinion, would not be in compliance with the audited financial statement requirements.

During the offering, the issuer would be required to amend its disclosures for any material change in the offer terms or disclosures previously provided to investors.

Advertising for the crowdfunding offering would be limited to a notice that includes the address of the intermediary's platform on which additional information about the issuer and the offering may be found. The proposed rules would limit notice advertising to:

  • 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 such as the amount of securities offered, the nature of the securities, the price of the securities, and the closing date of the following 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.

Requirements on Intermediaries

The JOBS Act outlines that any person acting as an intermediary in a transaction involving the Crowdfunding Exemption must be registered with the SEC as either a broker or a funding portal and become a member of the Financial Industry Regulatory Authority, Inc. (FINRA). As both brokers and funding portals would be members of FINRA, the proposed rules have set aside the ability of FINRA to propose requirements for persons associated with a funding portal. Associated persons of a funding portal are to be defined to include any:

  • Partner, officer, director or manager of a funding portal;
  • Person directly or indirectly controlling or controlled by a funding portal; or
  • Employee of a funding portal, but would exclude any persons whose functions are solely clerical or ministerial.

To avoid potential or perceived conflicts of interest, the intermediary itself and not just its directors, officers or partners, would be prohibited from having any financial interest in an issuer using its services, whether such interest would be received or purchased. Additionally, the intermediary, when establishing an account, would have to clearly disclose the manner in which it will be compensated in connection with the issuer's offering and sales. At the account opening, the intermediary would also have to inform investors that any person who promotes an issuer's offering for compensation must clearly disclose such compensation in all communications on the intermediary's platform; such promotion is allowed so long as the intermediary is not provided with personally identifiable information.

In an attempt to reduce the risk of fraud, the proposed rules require an intermediary to have a reasonable basis for believing that the issuer is in compliance with relevant regulations and has established means to keep accurate records of holders of the securities it offers. A reasonable basis may be established on representations of the issuer, absent knowledge or other information or indications that the representations are not true. If the intermediary cannot form such a reasonable basis, then the intermediary must deny access to the issuer.

The intermediary also would have responsibilities to investors. A prerequisite for conducting a Crowdfunding Exemption transaction is that the investor opens an account with the intermediary and consent to the electronic delivery of materials. The intermediary could provide required information to investors through an electronic message that contains the information, a link to the information posted on its platform, or through an electronic message that provides notice of what the information is ant that it is on the intermediary's platform or on the issuer's website.

Required information includes educational materials that are in plain language, provided to investors at account opening. Intermediaries would also need to ensure educational materials available on their platforms are current. The materials would need to include, among other things:

  • The process for the offer, purchase and issuance of securities through the intermediary;
  • The risks associated with investing in securities offered and sold;
  • The restrictions on the resale of securities offered and sold;
  • The limitations on the amounts investors may invest; and
  • The circumstances in which the issuer may cancel an investment commitment.

To ensure a proper acknowledgement of risk, the proposed rules require an intermediary, each time before accepting an investment commitment, to obtain from the investor a representation that the investor has reviewed the intermediary's educational materials, understands that the entire amount of his or her investment may be lost and is in a financial condition to bear the loss of the investment. The intermediary would also be required to ensure that the investor understands that there are restrictions on the investor's ability to cancel an investment commitment and obtain a return, that it may be difficult for the investor to resell the securities, and that the investor should not invest any funds in a crowdfunding offering unless he or she can afford to lose the entire amount of his or her investment.

The proposed rules would require an intermediary, upon receipt of an investment commitment from an investor, to promptly give or send to the investor a notification disclosing: (1) the date of the transaction; (2) the type of security that the investor is purchasing; (3) the identity, price and number of securities purchased by the investor, as well as the number of securities sold by the issuer in the transaction and the price(s) at which the securities were sold; (4) certain specified terms of the security, if it is a debt or callable security; and (5) the source and amount of any remuneration received or to be received by the intermediary in connection with the transaction, whether from the issuer or other persons.

The proposed rules would give an investor an unconditional right to cancel an investment commitment for any reason until 48 hours prior to the deadline identified in the issuer's offering materials. Thereafter, an investor would not be able to cancel any investment commitments made within the final 48 hours, except in the event of a material change to the offering. If an issuer reaches the target offering amount prior to the identified deadline, it may close the offering once the target offering amount is reached, provided that:

  • The offering will have remained open for a minimum of 21 days;
  • The intermediary provides notice about the new offering deadline at least five business days prior to the new offering deadline;
  • Investors are given the opportunity to reconsider their investment decision and to cancel their investment commitment until 48 hours prior to the new offering deadline; and
  • At the time of the new offering deadline, the issuer continues to meet or exceed the target offering amount.

If there is a material change to the terms of an offering, the intermediary would be required to send to any potential investors, notice of the material change stating that the investor's investment commitment will be cancelled unless the investor reconfirms their commitment within five business days of receipt of the notice. If the investor fails to reconfirm, the investment commitment will be cancelled and the funds will be redirected to the investor.

Additional Requirements on Funding Portals

As funding portals are not subject to the same regulatory requirements as brokers, the proposed rules would require, as a condition of registration, that a funding portal have in place, and thereafter maintain for the duration of such registration, a fidelity bond that: (1) has a minimum coverage of $100,000; (2) covers any associated person unless otherwise excepted by FINRA; and (3) meets any other applicable requirement by FINRA.

In an attempt to provide a non-exclusive safe harbor for certain limited activities, the proposed rules allow funding portals to engage in activities that relate to:

  • Limited offerings made on or through the funding portal's platform based on eligibility requirements, such as issuers in certain industries or geographic locations;
  • Highlighting and displaying offerings on the platform (e.g., type of security offered or the number of investment commitments made);
  • Providing communication channels for potential investors and issuers, though the funding portal could not participate in these communications other than to establish guidelines and remove abusive or fraudulent communications;
  • Providing search functions on the platform (e.g., categorizing offerings into general subject areas or, on a more granular level, the percentage of the target offering amount that has been met);
  • Advising issuers on the structure or content of offerings, including preparing offering documentation;
  • Compensating others for referring persons to the funding portal and for other services so long as the funding portal is not provided with personally identifiable information of any potential investor;
  • Creation of compensation arrangements with registered brokers which are not under similar constraints as funding portals; and
  • Advertising the funding portal's existence, not limited to any particular communication medium.

All provisions of the safe harbor require that the criteria used by the intermediary be applied objectively, be designed to highlight a broad selection of issuers, be applied consistently, and not be based on an assessment of the merits of a particular issuer or offering.

To ensure compliance with the federal securities laws, the proposed rules require that funding portals implement written policies and procedures; comply with anti-money laundering provisions; follow the same privacy rules that are applicable to brokers; and permit the examination and inspection of all of its business and business operations that relate to its activities as a funding portal, such as its premises, systems, platforms and records, by the SEC and FINRA representatives.

To allow for a meaningful audit trail for regulators, the proposed rules would require a funding portal to create and maintain certain records of the crowdfunding transactions and communications. The funding portal would be required to make and preserve certain records for five years, with the records retained in a readily accessible place for at least the first two years. The recordkeeping requirements include all information relating to educational materials; offers to sell and attempts to sell; records of all communications that occur on or through its platform; all notices provided by the funding portal to issuers and investors; and would require the funding portal to create and maintain daily, monthly and quarterly summaries of transactions effected through it.

Miscellaneous Provisions

Insignificant Deviations from the Regulations: The proposed rules provide for a safe harbor for insignificant deviations from the regulations by issuers. To qualify for the safe harbor, an issuer relying on the exemption would be required to show that:

  • The failure to comply with a term, condition or requirement was insignificant with respect to the offering as a whole;
  • The issuer made a good faith and reasonable attempt to comply with all applicable terms, conditions and requirements of Regulation Crowdfunding; and
  • The issuer did not know of the failure to comply, where the failure to comply with a term, condition or requirement was the result of the failure of the intermediary to comply with the requirements of Section 4A(a) of the Securities Act and the related rules, or such failure by the intermediary occurred solely in offerings other than the issuer's offering.

Exchange Act Count of Equity Holders: Under Section 12(g) of the Exchange Act, if an issuer has a class of securities held by either 2,000 persons or 500 persons who are not accredited investors, an issuer must register the class of securities with the SEC. As crowdfunding would bring issuers into close proximity with, if not, exceed the number of investors detailed in Section 12(g), the proposed rules exempt securities issued pursuant to the Crowdfunding Exemption from the record holder count under Section 12(g).

Liability of the Issuer for "Anti-Fraud" Violations: Despite an issuer being exempt from registration under the Crowdfunding Exemption, the JOBS Act provides that the issuer will be liable to a purchaser of its securities if the issuer makes an untrue statement of a material fact or omits to state a material fact required to be stated in order to make the statements which were made not misleading. Under this liability provision, an investor who purchases securities through a crowdfunding transaction has a private-right of action against the issuer to recover the consideration paid for the security, with interest, or damages if the person no longer holds the security.

Bad-Actor Provisions: The disqualification provisions included in Section 302(d) of the JOBS Act requires the SEC to adopt rules substantially similar to previous "bad actor" provisions modeled on Rule 262 of Regulation A. The proposed rules would apply the disqualification provisions to:

  • The issuer and any predecessor of the issuer of affiliated issuer;
  • Any director, officer, general partner or managing member of the issuer;
  • Any 20 percent beneficial owner;
  • Any promoter connected with the issuer in any capacity at the time of the sale;
  • Any person that has been or will be paid (directly or indirectly) remuneration for solicitation of purchasers in connection with sales of securities in the offering ("compensated solicitor"); and
  • Any director, officer, general partner or managing member of any such compensated solicitor

Comment Period

The comment period for the proposed rules will run for 90 days from publication in the Federal Register. The SEC has asked for comments on, among other things:

  • Should the SEC require that certain exempt offerings by included in the calculation of the $1 million limit?
  • Should the issuer be permitted to rely upon an intermediary in order to determine the aggregate amount of securities purchased by an investor, provided that the issuer does not have knowledge that the investor has exceeded or would exceed the limit?
  • Does the exclusion of issuers that do not have a specific idea or business plan from eligibility to rely on Section 4(a)(6) strike the appropriate balance between the funding needs of small issuers and the information requirements of the crowd?
  • Should the SEC exempt issuers with no operating history or issuers that have been in existence for fewer than 12 months from the requirement to provide financial statements?
  • Should the issuer be able to terminate its annual reporting obligation in circumstances other than those provided in the proposed rules?
  • Should the SEC exempt certain issuers from ongoing reporting obligations (e.g., those raising a certain amount, such as $100,000 or less)?
  • Is a reasonable basis the appropriate standard for intermediaries making determinations in whether issuers comply with the requirements in Section 4A(b) of the Securities Act?
  • Instead of, or in addition to, requiring that intermediaries make issuer information available on their platforms, should we require that intermediaries deliver this information to investors?
  • Should the SEC require an intermediary to avail itself of readily available information concerning investor limits, such as a centralized database containing information relating to whether particular investors were in compliance with the investment limits, should one become established?
  • Is it appropriate for the SEC to require a funding portal to have a fidelity bond?
  • Are there any additional conditions that should apply to the activities covered under the proposed safe harbor?
  • Should the SEC define the term "insignificant" or use a different term in creating the issuer safe harbor?

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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