United States: SEC Sets Limits On Crowdfunding

Originally published by Law Journal Newsletters, (Entertainment Law & Finance)

On Oct. 30, 2015, the U.S. Securities and Exchange Commission (SEC) issued new regulations to complete its work for implementing the sections of the JOBS Act that, for the first time, permit use of the Internet to raise equity financing. These latest regulations are scheduled to go into effect on May 16, 2016.

What do the new regulations mean for entertainment industry companies and individuals seeking to raise capital? The new regulations go along with two prior regulations implementing the JOBS Act: the regulations permitting Internet equity offerings only to accredited investors (a new Rule 506(c)), and regulations amending Regulation A to permit equity offerings of up to $20 million (a "Tier 1 offering") or up to $50 million (a "Tier 2 offering"). (See the author's coverage of Regulation A, starting on page one of the May 2015 issue of Entertainment Law & Finance, http://bit.ly/1OhWl6f.)

As though crowdfunding is not confusing enough, encompassing the donation model — such as Kickstarter, Indiegogo, Rockethub and other platforms — as well as the equity model in which people put money into a project with the hope of receiving it back with a profit, the SEC has elected to call this third round of regulations "Regulation Crowdfunding" (as though the prior two regulations do not also regulate the use of the Internet to raise capital). Consistent with this label by the SEC, this article will refer here to this new set of regulations as "Regulation CF." Consistent with Title III of the JOBS Act, Regulation CF imposes limits on issuers, investors and platforms using the Internet to raise capital.

Issuer Limitations

An issuer cannot use Regulation CF to raise more than $1 million in a 12-month period. The monetary limit is the gross amount to be raised, before taking costs of the offering into account.

If an issuer is raising less than $100,000, instead of financial statements, the issuer can include in its offering materials three items from its tax returns: gross income, adjusted net income and the amount of taxes paid, certified as accurate by the chief executive officer or manager of the issuer. If an issuer is raising $100,000 to $500,000, it must include reviewed annual financials. If an issuer is raising $500,000 to $1 million, the offering material financial information must include audited financial statements.

If an issuer is a startup in its first year so that none of the above are available, it must have a business plan and pro forma financials, including discussion of its anticipated burn rate before the money being raised is gone.

The issuer must use a platform for the offering that is either a registered broker dealer or a "funding portal" (a digital platform) registered with the SEC and with a regulatory body of which the only one at present is the Financial Industry Regulatory Authority (FINRA). The issuer can communicate with investors and potential investors only by means of the one platform used for the offering. If the issuer wants to bring in investors through its own website, that website can only direct interested parties to the platform on which the offering information is available.

If a material event occurs during the offering period (for example, a major change in a film script, a commitment by a director or principal cast member, engaging a foreign sales agent or making a distribution deal), it must notify all investors by email and give them a chance to withdraw their commitment.

In general, investors who have made a commitment can withdraw it for any reason or no reason up to 48 hours before the offering closes and the money can be used. The issuer must use an escrow agent to handle funds until the closing.

A platform has an obligation to monitor the registration and transfer of securities, a cost that will be passed along to the issuers using the platform. This obligation on a platform does not apply if an issuer uses a transfer agent registered with the SEC, so some platforms may not even be willing to undertake the monitoring obligation unless the issuer uses such a transfer agent (an additional annual cost to the issuer).

Because an Internet offering reaches a worldwide audience, issuers also need to be aware of foreign securities law requirements before they accept an offer to subscribe from a potential investor outside the United States (as is true for the other two Internet offerings authorized by SEC regulations).

Investor Limitations

Investors cannot invest more than $100,000 a year in all offerings under Regulation CF. (Note that this limitation does not apply to investments by a non-accredited investor under a Regulation A Internet offering.) In addition, there are limits on what an investor can invest based on annual income or net worth, both calculated together with a spouse or significant other if applicable:

  • If either annual income or net worth is less than $100,000 a year, the maximum that can be invested with an issuer is the greater of $2,000 or 5% of the lesser of annual income or net worth (and subject to the overall cap of $100,000 a year); or
  • If both annual income and net worth are $100,000 or over, then 10% of the lesser of annual income or net worth (and subject to the overall annual $100,000 cap).

Platform Limitations

There are a variety of limitations on, and requirements of, platforms that host a Regulation CF offering. An issuer runs a risk if a platform does not comply with all of these obligations, because the issuer would then be in violation of the securities laws even though that violation results from actions by the platform, not from actions by the issuer.

For entertainment industry companies and individuals, in making a decision about whether or not to use Regulation CF to raise capital the first step is to evaluate the costs that will be incurred and to factor those costs into the business plan use of the proceeds that will be part of the offering information.

For certain projects, the cap of $1 million may not be a concern. Raising finishing funds, or money needed to distribute or to promote a completed project, are two examples where the money to be raised would be sufficient to achieve the investment goal. Certain documentaries or web series can be financed with less than $1 million. Even development financing may be a possibility if the project has enough "buzz" to attract investors.

The author of this article believes that the new Tier 1 Regulation A offerings, where an issuer can use its own website to raise up to $20 million a year, will likely be the most attractive way to raise equity over the Internet, because that amount can be sufficient for many entertainment projects or even slates or groups of projects — even though the two regulatory filings (one with the SEC and one with one of the 50 state securities regulatory agencies) required by a Tier 1 offering mean that an issuer needs to plan far enough in advance to go through the filings before beginning to use the money raised in the offering. In addition there are no limits on how much non-accredited investors can raise in a Tier 1 offering, which also may make it the most attractive of all the SEC regulations governing Internet offerings of securities.

www.fkks.com

This alert provides general coverage of its subject area. We provide it with the understanding that Frankfurt Kurnit Klein & Selz is not engaged herein in rendering legal advice, and shall not be liable for any damages resulting from any error, inaccuracy, or omission. Our attorneys practice law only in jurisdictions in which they are properly authorized to do so. We do not seek to represent clients in other jurisdictions.

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