United States: Crowdfunding Update: Still Stuck

On April 10, 2014, the Investor Advisory Committee to the Securities and Exchange Commission issued six recommendations with respect to the SEC's proposed crowdfunding regulations.  The recommendations amount to a re-write assignment to the SEC principally to make it harder for smaller investors to participate in crowdfunding offerings with a stated goal of investor protection. This has furthered criticism of the SEC in this area. All in all, the current status of crowdfunding reminds me of a catch phrase from one of my young daughter's favorite books about the various efforts of a cast of woodland creatures to free a duck stuck in some mud, "no luck, still stuck."

By way of background, crowdfunding, an internet-based method for capital raising by start-up companies from a wide range of investors, was forced on the SEC in 2012 by Congress under the 2012 Jumpstart Our Business Startups Act ("JOBS Act"). The legislation was supposed to allow a broad range of the general public to invest in start-ups and participate in those companies' growth prospects. This type of a system would jostle bedrock securities regulation principles in place for decades which generally require a company seeking to raise capital to either file a full-blown registration statement for the securities before sale to the general public (think IPO on the NYSE) or conduct a private placement.  A full-blown registration statement is subject to SEC vetting, disclosure and marketplace scrutiny by investment professionals. This provides investors with the benefit of full information and regulatory oversight which, in theory, reduces opportunities for fraudsters to fleece ordinary investors through the sale of bogus securities or unscrupulous marketing or trading activities. In a typical private placement, the issuer markets the securities in a much more limited fashion to wealthy, sophisticated investors (called "accredited investors in SEC parlance) who can both look after themselves and afford to lose the money invested. In this way, the securities regulators seek to protect those investors most in need of safeguards while allowing for capital raising necessary to growth in the economy.

One critique of this regulatory regime is that ordinary investors are not able to "get in early" on promising companies in the same way that venture funds and wealth angel investors can.  Enter crowdfunding via the JOBS Act. The statute essentially opens investment in these types of companies up to ordinary investors subject to a lighter regulatory hand than would otherwise apply in securities offerings. State and federal securities regulators generally opposed this as they viewed it as more open to fraud and, in any event, too risky for people who can't afford to own this high-risk class of investment. Nevertheless, the legislation directed the SEC to issue rules to implement the crowdfunding provisions of the JOBS Act.

Only about a year and half later, the Securities and Exchange Commission finally unveiled "Regulation Crowdfunding," – the proposed regulations. Highlights of the proposed regulations follow:

  • Eligible businesses can raise up to $1 million through one or more equity crowdfunding offerings during a 12-month period. These securities offerings are exempt from further SEC regulation, as long as the offering is conducted over the internet through a registered intermediary or "funding portal" and complies with the provisions of Regulation Crowdfunding. Securities that are sold through a crowdfunding offering are subject to a one-year holding period, during which time investors cannot trade or sell the securities on the secondary market.
  • Graduated financial disclosure requirements based on the size of the offering. Issuers offering securities in the amount of $100,000 or less are only required to file income tax returns for the most recently completed year and financial statements certified by the principal executive officer. Those offering between $100,000 and $500,000 must file financial statements reviewed by an independent public accountant. Issuers offering greater than $500,000 of securities must file audited financial statements prepared in accordance with GAAP.
  • Regardless of size, all issuers are required to disclose certain information about the business, including information regarding the company's current business plan; a description of the financial condition of the company and anticipated use of the offering proceeds; information about officers, directors, and owners of 20% or more of the company; the target offering amount and deadline for reaching that target; the price of the securities and the method used to determine the price; and relevant risk factors. The SEC has proposed that all issuers file these mandated disclosures on the EDGAR electronic filing platform using a new "Form C." Issuers will also be required to file annual reports with the SEC that they must make available to all investors.  This obligation continues until the issuer becomes a reporting company (files quarterly, annual and periodic reports like an NASDAQ or NYSE company), all crowd-funded securities are redeemed or bought by another party or the issuer goes out of business.
  • Over the course of a 12-month period, individual investors are permitted to invest in businesses through registered intermediaries, referred to as "crowdfunding portals," subject to certain aggregate investment limits based on the investor's annual net income or net worth. If an individual investor's annual net income or net worth is less than $100,000, that individual would be permitted to invest $2,000 or 5 % of their annual income or net worth, whichever is greater. If an individual investor's annual net income exceeds $100,000, that individual would be permitted to invest up to 10% of their annual income or net worth, up to a maximum of $100,000 of securities purchased through crowdfunding.
  • Other requirements include the electronic delivery of certain investor education materials and regulations related to the conduct and compensation of the funding portals.

Public comment on those rules closed on  February 3, 2014. The public comments show that the proposed rules were met with strong criticism from concerned investors, individuals, businesses, and state regulators throughout the 90-day public comment period. Investors and businesses generally took issue with the proposed investment limitations, the $1 million offer cap, and the potentially burdensome compliance costs and disclosure requirements. State securities regulators, on the other hand, voiced concerns over the risk of fraud and insufficient investor protection mechanisms.

The Investor Advisory Committee considered these comments and clearly sided with the regulators in making six recommendations certain highlights of which are set forth below:

  • Limit investor exposure to losses by further limiting the annual amount that can be invested by non-accredited investors in crowdfunding offerings "...to avoid investor concentration in start-ups as an asset class."
  • Require portals to collaborate to ensure that investors can't "portal-hop" and further concentrate investments in start-ups. Essentially, under the proposed regulations, portals can control investor participation within the net worth and income requirements only on that portal. An investor could go to a different portal and invest in further start-ups because portal 2 will not know about the investor's participation in portal 1. The recommendation would require portals to share data to try to avoid this.
  • Allow portals to reject investors and offerings "that they believe could pose an undue compliance or fraud risk."
  • As the committee viewed the portion of the proposed regulations that required certain educational materials to be provided to investors about investing and its risks as being too passive, the committee wants the SEC to "..take further steps to ensure that educational materials clearly convey the required information and are reviewed and, to the degree possible, understood by investors." Think online quizzes for investors here.
  • Force the portals to provide the disclosures and educational materials to the investors electronically and not just by pointing to certain links to pages on the website.
  • As the committee was critical that the proposed regulations provided that crowdfunding offerings would not be integrated with other offerings conducted by the issuer, it recommended that the SEC "...require crowdfunding offerings to be integrated with offerings in reliance on a separate exemption where needed and appropriate to prevent evasion of regulatory requirements."

The net result of all this is that we should expect further delay before final regulations are implemented. In addition, there is no reason to anticipate that, when implemented, the final regulations will be any less complex than the proposed regulations. For instance, it is clear that in addition to the offering amount limitations, the reporting and disclosure requirements imposed by Regulation Crowdfunding will not be insignificant and could result in considerable audit, compliance, and intermediary commission costs for issuers. When compared with a standard private placement to accredited investors, it will be rare when the crowdfunding option prevails after a cost/benefit analysis. In any event, don't expect the crowdfunding duck to be out of the muck any time soon.

The author gratefully acknowledges the contributions to this piece made by Bradford M. Melson, a law clerk.

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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