United States: SEC Adopts Final Rules For Securities Crowdfunding Under Title III Of The JOBS Act

Background

Crowdfunding involves the use of the Internet by individuals or organizations to find other people or organizations to fund their projects, often artistic or charitable endeavors as well as personal and business projects, typically in exchange for a future service, product or other benefit. A crowdfunding campaign typically has a target amount of funds to be raised and an identified use for those funds. Because the Internet is the venue for crowdfunding activities, those seeking funds can appeal to anyone anywhere. Those who are interested in a crowdfunding campaign can in turn use the Internet to share information about the project with others, generating the "wisdom of the crowd" to collectively identify and reward, with a financial contribution, those projects deemed most attractive, or to reject those projects deemed unworthy or a mere "sham."

To date, crowdfunding generally has not been used by businesses seeking to raise capital in exchange for securities of the business because doing so would trigger the application of the Securities Act of 1933 (Securities Act), under which the offer and sale of securities is required to be registered with the SEC unless an exemption applies.

The JOBS Act provides such an exemption by adding Section 4(a)(6) to the Securities Act to permit eligible issuers to conduct limited sales of securities without registration under the Securities Act through Internetbased crowdfunding activities intermediated by either a registered broker-dealer or a funding portal.4 In addition, it exempts such issuers from state blue sky registration provisions (but not state anti-fraud provisions). Although the JOBS Act is in effect, its crowdfunding provisions could not be relied upon until the SEC, and FINRA with respect to funding portals, adopted final rules implementing securities-based crowdfunding.

The SEC's final rules, as required, closely track the provisions of the JOBS Act, including new Securities Act Section 4(a)(6). Under Section 4(a)(6):

  • The amount raised by an issuer must not exceed US$1 million in a 12-month period.
  • An investor is limited in the amount he/she may invest in crowdfunding securities in any 12-month period across all issuers.
  • Transactions must be conducted through an intermediary that is registered either as a broker-dealer or a funding portal.

In addition, the crowdfunding provisions of the JOBS Act add:

  • Section 4A to the Securities Act, which requires, among other things:
  • Issuers and intermediaries relying on the crowdfunding exemption to provide certain information to the SEC, investors and potential investors
  • Funding portals to register as such (or as a broker-dealer)
  • Section 3(h) to the Securities Exchange Act of 1934 (Exchange Act), which requires the SEC to adopt rules exempting funding portals from having to register as brokers or dealers pursuant to Exchange Act Section 15(a)(1)
  • Section 12(g)(6) to the Exchange Act, which requires the SEC to adopt rules exempting securities acquired pursuant to an offering made in reliance on the crowdfunding exemption from the registration requirements of Section 12(g)

Overview

Prior to issuing its initial proposal, the SEC solicited public input on each title of the JOBS Act, including Title III.5 The adopting release also references and analyzes comments the SEC received during the postproposal period.6 In the adopting release for the new rules, the SEC acknowledges the need to balance the protection of ordinary investors from fraud against Congress' goal of reducing regulations on capital raising for startups and small companies. Many believe that securities-based crowdfunding may offer a potential solution to small businesses' funding problems. They point to the success of nonsecurities based crowdfunding activities through which individuals and organizations reportedly raised approximately US$2.7 billion in funding worldwide in 2012. However, even the strongest advocates of securities-based crowdfunding acknowledge the potentially substantial risks to investors. Investing in small businesses is inherently risky, as many new business ventures fail. Furthermore, small business investments tend to be highly illiquid since most such offerings are too small to support any active secondary trading market.

In addition to those risks, state securities regulators and others have commented that small business investments may pose higher risks of fraud, self-dealing and overreaching by controlling shareholders. The JOBS Act and the new SEC rules attempt to address such risks by: (i) establishing issuer eligibility requirements that prohibit certain issuers from engaging in securitiesbased crowdfunding under the new exemption; (ii) requiring issuers to make specific disclosures to potential investors and the SEC in prescribed ways; (iii) strictly limiting the amount a single investor can invest within a 12-month period in securities-based crowdfunding offerings, as noted above and explained further below; and (iv) requiring a single funding portal or registered broker-dealer to act in the dual role of gatekeeper and facilitator between potential investors and the issuer. Under the SEC's rules, the intermediary is required to perform functions and implement procedures designed to protect investors. For example, the intermediary must provide an online communication platform for the issuer to make required disclosures and for the crowd to share information about potential investments.

Final rules

Issuer sale and investor purchase limits

The SEC's rules implement the requirements in Section 4(a)(6) that strictly limit the amounts of securities an eligible issuer can sell to investors in any 12-month period. The limitations are as follows:

  • The aggregate amount an eligible issuer may sell to all investors during the prior 12-month period may not exceed US$1,000,000.7 This limitation is independent of any money raised pursuant to other exemptions, such as Regulation D, meaning that capital raised under other exemptions does not count toward the US$1,000,000 limit under Section 4(a)(6).
  • The aggregate amount an investor may invest in all crowdfunding offerings (whether made by one or more issuers) during the prior 12-month period may not exceed:
  • The greater of US$2,000 or 5 percent of the lesser of the investor's annual income or net worth, if either the investor's annual income or net worth is less than US$100,000
  • Ten percent of the lesser of the investor's annual income or net worth, if both the investor's annual income and net worth are US$100,000 or more, provided that no investor may invest more than US$100,000 regardless of annual income or net worth8 The rules require a natural person's annual income or net worth to be calculated in accordance with the rules for determining accredited investor status.9

Securities-based crowdfunding transactions must be conducted exclusively over the Internet on a "platform" through either a broker-dealer or a funding portal intermediary. A platform is defined as "a program or application accessible via the Internet or other similar electronic communication medium through which a registered broker or a registered funding portal acts as an intermediary in a transaction involving the offer or sale of securities." Each issuer is required to use only one intermediary so that the intermediary, among other things, can help ensure that neither the issuer nor any investor is exceeding the applicable aggregate issuer sale and investor purchase limits. Intermediaries are prohibited from soliciting investments or providing investment advice; however, the final rules change the proposed rules to permit an intermediary to engage in back office and other administrative functions off the intermediary's platform.

Resale restrictions

While securities-based crowdfunding transactions involve public offers and sales exempt from registration under the Securities Act, securities sold in a crowdfunding transaction are subject to transfer restrictions that prohibit an investor from reselling such securities for one year,10 except when transferred:

  • To the issuer of the securities
  • To an accredited investor11
  • As part of an offering registered with the SEC
  • To a family member of the purchaser, a trust controlled by the purchaser, a trust for the benefit of a family member, or in connection with the death or divorce of the purchaser

Requirements for issuers

Issuer eligibility

To rely on the exemption provided under Section 4(a)(6), the issuer must be a company incorporated in or organized under the laws of a US state or territory. Certain entities are prohibited from engaging in securities-based crowdfunding offerings under Section 4(a)(6) as follows:

  • All foreign issuers, including Canadian issuers
  • Issuers already subject to SEC reporting requirements
  • Investment companies registered or required to be registered under the Investment Company Act of 1940
  • "Blank-check" companies that have no specific business plan or have indicated their business plan is to engage in a merger or acquisition with an unidentified company
  • Companies that have failed to comply with the annual reporting and disclosure requirements under Regulation Crowdfunding during the two years preceding the filing of the offering statement12

Offering disclosure requirements

All mandated disclosures, discussed in detail below, must be made on the intermediary's website for access by investors and also via the SEC's EDGAR filing system using new Form C. According to the SEC, the benefit of Form C is that it provides key offering information in a standardized format, while also giving the issuers a degree of flexibility in the presentation of other required information.

Financial statement requirements

An issuer offering or selling securities in reliance on Section 4(a)(6) must prepare comprehensive disclosure about itself and the offering. The issuer must file this disclosure with the SEC publicly via EDGAR on Form C and make it available on the intermediary's platform for review or download by potential investors at least 21 days before any securities may be sold.

The type of financial statements an issuer is required to provide depend on the amount the issuer is seeking to raise in the crowdfunding transaction, as follows:

  • If targeting US$100,000 or less: The amount of total income, taxable income and total tax or equivalent line items, as reported on the federal tax forms filed by the issuer for the most recently completed year (if any), certified by the principal executive officer of the issuer, and the financial statements of the issuer, also certified by the principal executive officer.13 However, if financial statements of the issuer that have either been reviewed or audited by a public accountant independent of the issuer are available, then the issuer must provide these financial statements instead of the materials described in the preceding sentence.
  • If targeting more than US$100,000 and less than US$500,000: Financial statements of the issuer reviewed by a public accountant independent of the issuer.14 If financial statements of the issuer that have been audited by a public accountant independent of the issuer are available, the issuer must provide those instead of the reviewed statements.
  • If targeting more than US$500,000: Financial statements of the issuer audited by a public accountant independent of the issuer; provided, however, that for issuers that are first-time issuers, financial statements of the issuer reviewed by a public accountant independent of the issuer would suffice. If audited financial statements are available, those must be provided instead. All financial statements must be prepared in accordance with US GAAP and include a balance sheet, income statement, statement of cash flows, and changes in owners' equity for two years (or since inception if less than two years).

Where an issuer sets a target amount but is willing to accept more than that target, the issuer must disclose the maximum amount it will accept and provide disclosure about the intended use of the additional proceeds, the method of allocation of the abovetarget shares and other disclosures.

Additionally, the financial statement requirement is based on the maximum amount the issuer is willing to accept rather than the target amount.15

In addition to financial statements, the issuer must present a narrative discussion of its financial condition, which discussion is conceptually similar to the management's discussion and analysis required by Item 303 of Regulation S-K for registered offerings (MD&A). While the SEC did not prescribe the content or format of such information, it stated that the discussion here need not be as lengthy or detailed as the MD&A but should address the issuer's historical results of operations, liquidity and capital resources.16

Where an issuer is conducting a "follow-on" offering, the financial statements requirements are based on the aggregate amount offered by such issuer during the 12-month period prior to and including the target amount of the current offering. Thus, for example, if an issuer has made a prior offering with a target amount of US$400,000, and such issuer seeks to conduct another crowdfunding offer with a target of US$200,000, it must provide audited financial statements as the aggregate amount of the two offerings would exceed US$500,000.17

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Footnotes

1 A funding portal is defined as a crowdfunding intermediary that does not: (i) offer investment advice or recommendations; (ii) solicit purchases, sales, or offers to buy securities offered or displayed on its website or portal; (iii) compensate employees, agents, or other persons for such solicitation or based on the sale of securities displayed or referenced on its website or portal; (iv) hold, manage, possess, or otherwise handle investor funds or securities; or (v) engage in such other activities as the SEC, by rule, determines appropriate.

2 FINRA recently filed with the SEC a proposal for regulating funding portals, which is available at http://www.finra.org/sites/default/files/ rule_filing_file/FINRA recently filed with the SEC a proposal for regulating funding portals, which is available at http://www.finra.org/sites/default/files/ rule_filing_file/SR-FINRA-2015-040.pdf.

3 The forms permitting the funding portals to register with the SEC will be effective on January 29, 2016.

4 In this paper, we generally refer to such activities as "securities-based crowdfunding." The SEC's rules are also often described elsewhere as relating to "equity crowdfunding" in light of the view that such crowdfunding activities, once permitted, are likely to involve offers and sales of equity. We note, however, that the SEC's rules are not limited to equity offerings.

5 The public comments received by the SEC on Title III, referred to in this paper as "Title III comments," are available on its website at http://www.sec.gov/comments/jobs-title-iii/jobs-title-iii.shtml.

6 The comments about the proposed rules can be found at http://www.sec.gov/comments/s7-09-13/s70913.shtml.

7 The SEC is required to adjust this amount for inflation at least once every five years.

8 These final rules clarify the ambiguity in the SEC's proposed rules about whether the 5 percent and 10 percent limits applied to the lesser or greater of the investor's annual income or net worth (if they differed) and which limit applied if only one of the investor's annual income or net worth was greater than US$100,000. Thus, under the final rules, an investor with net worth of US$80,000 and annual income of US$150,000 would have an investment limit of US$4,000, i.e., 5 percent of US$80,000.

9 See Securities Act Rule 501(a)(5) (net worth) and Securities Act Rule 501(a)(6) (income). The calculation of net worth excludes the value of the investor's primary residence.

10 The adopting release notes that the final rule differs from the proposed rule in that the one-year resale restriction applies to any purchaser during the one-year period beginning when the issuer first issues the securities, not just the initial purchaser.

11 The person reselling the securities must have a "reasonable belief" that the purchaser is an accredited investor.

12 When the issuer remedies such compliance failure by filing the required documents with the SEC, the issuer may again rely on the Section 4(a)(6) exemption. The final rules also require an issuer to disclose in its offering statement and annual report if it (or any of its predecessor companies) previously failed to comply with Regulation Crowdfunding's reporting requirements.

13 Unlike the proposed rules, the final rules do not require the issuer to produce a copy of the tax returns.

14 The final rules amend the definition of "independent" in this context to allow for compliance with the independence standards of the American Institute of Certified Public Accountants (AICPA) as an alternative to compliance with the SEC's independence rules in SEC Rule 2-01 of Regulation S-X.

15 See Regulation Crowdfunding, Rule 201(t)(3) and Instruction 1 to paragraph (t).

16 If an issuer has a prior operating history, the discussion should also focus on whether historical earnings and cash flows are representative of what investors should expect in the future. If the issuer does not have a prior operating history, the discussion should focus on financial milestones, liquidity and other operational challenges.

17 See Regulation Crowdfunding, Rule 201(t)(3) and Instruction 1 to paragraph (t).

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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