On October 30th, the Securities and Exchange Commission (the “SEC”) adopted new crowdfunding rules, referred to as Regulation Crowdfunding. The rules were mandated by the Jumpstart Our Business Startups Act of 2012, with the goal of providing startups and small businesses with the opportunity to raise capital in a more cost-effective manner. In Part 1 of our three-part series on the crowdfunding rules (available here), we provided an overview of Regulation Crowdfunding. In this part, we are discussing the disclosure requirements applicable to issuers conducting a crowdfunded offering. In Part 3, we will discuss the role and obligations of crowdfunding intermediaries. The Regulation Crowdfunding adopting release is available here.
Securities crowdfunding will permit an issuer to raise relatively small amounts of money from a large number of investors over the internet. In connection with a crowdfunded offering under Regulation Crowdfunding, issuers are required disclose certain information about their business and the proposed offering and must prepare and file with the SEC an offering statement and annual reports.
If an issuer wants to rely on the exemption provided by Regulation Crowdfunding, what is it required to disclose?
An issuer offering or selling securities in reliance on the crowdfunding exemption must prepare a relatively detailed offering statement that includes specified information, including:
- the name, legal status, physical address and website of the issuer;
- certain information with respect to the issuer’s directors, officers and persons who are beneficial owners of 20 percent or more of the issuer’s outstanding voting equity securities, calculated on the basis of voting power;
- a description of the business and anticipated business plan of the issuer;
- the current number of employees of the issuer;
- risk factors, which should be tailored to the issuer’s business and the offering;
- the target offering amount and the deadline to reach such amount;
- whether the issuer will accept oversubscriptions and, if so, how they will be treated;
- the use of proceeds;
- a description of the process for completion of the transaction or cancellation of an investment commitment and the process for reconfirming investment commitments in the event of a material change of information;
- the offering price of the securities (or the method for determining such price);
- a description of the ownership and capital structure of the issuer;
- certain information relating to the intermediary, including any financial interest in the transaction;
- a description of the material terms of any indebtedness of the issuer;
- a description of exempt securities offerings conducted within the prior three years;
- a description of certain related-party transactions;
- a discussion of the issuer’s financial condition, including, to the extent material a discussion of the issuer’s liquidity, capital resources and historical results of operations (covering the period for which financial statements are provided, as discussed below);
- certain disqualification events with respect to the issuer and other covered persons;
- the location on the issuer’s website, and time of availability, of its ongoing annual reports under Regulation Crowdfunding, as well as any failure to comply with ongoing reporting requirements; and
- any material information necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading.
The disqualification events that must be disclosed in the offering statement are substantially similar to the existing “bad actor” disqualification events with respect to Rule 506 of Regulation D under the Securities Act of 1933, as amended (the “Securities Act”), and include certain criminal convictions, court injunctions and restraining orders, regulatory agency orders, SEC disciplinary, cease-and-desist and stop orders, suspension or expulsion from membership in self-regulatory organizations and U.S. Postal Service false representation orders.
In response to comments on the proposed crowdfunding rules and to ease issuers’ legal and administrative burdens in preparing an offering statement that addresses each of the items above, the SEC has also provided a streamlined Q&A version of an offering statement in plain English as part of the adopted Form C, as discussed in more detail below.
What financial information is required to be included in an offering statement?
Financial information is scaled based on the amount of the target offering size of the proposed transaction, plus all amounts sold by the issuer (and any entities controlled by or under common control with the issuer and all predecessors of the issuer) under Regulation Crowdfunding in the prior 12 months (the “Sale Amount”). Despite multiple comment letters on the proposed rules seeking exemptions from the financial statement requirements, all issuers, regardless of their size, period of corporate existence or their operating history, are subject to the financial statement requirements. The financial information required is as follows, based upon the Sale Amount:
- $100,000 or less: The issuer must provide (x) the amount of total income, taxable income and total tax (or equivalent line items) as reported on the U.S. federal income tax returns filed by the issuer for the most recently completed fiscal year, if any, and (y) the financial statements of the issuer, in both cases certified by the principal executive officer of the issuer to be true and complete in all material respects;
- More than $100,000 but not more than $500,000: The issuer must provide financial statements reviewed by a public accountant that is independent of the issuer; and
- More than $500,000: The issuer must provide financial statements audited by a public accountant independent of the issuer. In a significant nod to comments on the proposed rule, the final rule exempts the issuer’s first crowdfunded offering from this audit requirement and permits reviewed financial statements to be provided instead irrespective of whether the offering amount is greater than $500,000.
In each case, if reviewed or audited financial statements are available, those must be provided notwithstanding the fact that certified or reviewed financial statements, respectively, would have otherwise satisfied the financial statement requirements set forth above.
To qualify as independent under Regulation Crowdfunding, an accountant must satisfy the standards of either (i) Rule 2-01 of Regulation S-X under the Securities Act or (ii) the American Institute of Certified Public Accountants (“AICPA”). In addition, financial statement reviews must be conducted in accordance with the Statements on Standards for Accounting and Review Services issued by the Accounting and Review Services Committee of AICPA, and financial statement audits must be conducted in accordance with the standards of (i) the Public Company Accounting Oversight Board or (ii) AICPA (i.e., U.S. generally accepted auditing standards). Review and audit reports need not be accompanied by a formal consent or acknowledgment letter unlike audit reports in a registered public offering; instead, review and audit reports must be signed and the issuers must notify the public accountants of their intended use in a crowdfunded offering.
All financial statements must be prepared in accordance with U.S. generally accepted accounting principles and must include balance sheets, statements of comprehensive income, statements of cash flows, statements of changes in stockholders’ equity and notes to the financial statements.
These financial statements must cover the two most recently completed fiscal years or the period since incorporation, if shorter. For an offering conducted within the first 120 days of a fiscal year end, the financial statements provided may be for the two fiscal years prior to the issuer’s most recently completed fiscal year; after that 120-day period, however, the financial statements must cover the two most recently completed fiscal years.
What offering documents are required to be filed and provided to intermediaries and investors in connection with a crowdfunded offering?
Prior to commencement of the offering, the issuer must first electronically file the offering statement on Form C with the SEC’s EDGAR database and provide a copy to the intermediary and the investors. The Form C is an XML-based fillable form that requires certain disclosures to be presented in a specified format (including basic issuer and intermediary information, intermediary compensation, type and price of securities offered, information relating to oversubscriptions, offering deadline, current number of employees and selected financial data), while permitting the customization of other disclosure, which could be filed as exhibits to the Form C (e.g., relevant information presented on the intermediary’s platform such as a transcript of any video presentation and description of charts or graphs).
The issuer may satisfy its requirement to provide the required offering statement (as well as amendments thereto and progress updates, both as discussed below) to the intermediary by providing a copy of the disclosures filed with the SEC to such intermediary, and it may satisfy its requirement to provide them to investors if it refers such investors to the relevant information on the intermediary’s platform through a posting on the issuer’s website or by email.
As discussed in Part 1 of this Corporate Update, the issuer must also file with the SEC and provide to the intermediary and investors:
- any amendments to the offering statement, and, if the amendment includes material changes, the investors must reconfirm their investment commitment within five business days or such investor’s commitment will be deemed cancelled; and
- progress updates in meeting the target offering amount within five business days after reaching 50 percent and 100 percent of the target. (However, if the intermediary makes frequent publicly available updates on its platform regarding the issuer’s progress in meeting the target offering amount, no SEC filing is required, except for a final progress update filing on Form C-U to disclose the total amount of the securities sold in the offering, which must be filed within five business days after reaching the offering deadline.)
Each of the Form C/A (for amendments) and Form C-U (for progress updates), along with the Form C-AR (for annual reports, as discussed below) and Form C-TR (for terminating annual reporting obligations, as discussed below), uses the same basic Form C, except the issuer would check the appropriate box on the cover to indicate the purpose of the Form C filing. EDGAR would then automatically provide each filing with the appropriate tag depending on the box chosen on the cover page, permitting investors to distinguish between the types of filings.
What annual reporting obligations are triggered by use of Regulation Crowdfunding, and when are these reports due?
As discussed in Part 1 of this Corporate Update, any issuer that has sold securities in reliance on Regulation Crowdfunding must file with the SEC and post on its website an annual report on Form C-AR, within 120 days after the end of the fiscal year covered by the report. Any amendments to the annual report may be filed with the SEC on a Form C-AR/A.
The annual report must include substantially the same information as included in an offering statement filed on Form C, except that (i) information relating to the offering may be omitted and (ii) in lieu of the financial information required in the offering statement, the issuer may provide financial statements covering the two most recently completed fiscal years certified by the principal executive officer of the issuer to be true and correct in all material respects rather than audited or reviewed financial statements (unless any such reviewed or audited financial statements are available, in which case those must be provided instead) and a description of the financial condition of the issuer with respect to the period covered by the financial statements. The concession to provide only certified financial statements in annual reports was made by the SEC in response to multiple comment letters on the proposed rules that expressed concerns with the costs associated with preparing reviewed and audited financials on an ongoing basis.
Although the ongoing disclosure continues to be almost as extensive as the initial offering statement, the SEC was of the view that ongoing disclosure costs would be lower than the offering statement because issuers would be able to use the offering materials as a basis to prepare the annual reports.
How long is the issuer subject to annual reporting requirements?
The issuer must continue to comply with the annual reporting obligations until the earliest of the following events:
- the issuer becomes subject to the reporting obligations of Section 13(a) or Section 15(d) of the Securities Exchange Act of 1934, as amended;
- the issuer has filed, since its most recent sale of securities under Regulation Crowdfunding, at least one annual report and has fewer than 300 holders of record;
- the issuer has filed, since its most recent sale of securities under Regulation Crowdfunding, annual reports for at least the three most recent fiscal years and has total assets that do not exceed $10 million;
- the issuer (or another party) repurchases all of the securities issued in reliance on the crowdfunding exemption (including payment in full of debt securities or redemption of redeemable securities); or
- the issuer liquidates or dissolves its business in accordance with state law.
Upon becoming eligible to terminate its reporting obligations, an issuer must file a Form C: Termination of Reporting, or Form C-TR, within five business days of such eligibility, in order to advise investors that the issuer will cease reporting.
What happens if an issuer doesn’t comply with its ongoing disclosure obligations? Is the crowdfunding exemption unavailable?
The availability of the crowdfunding exemption under Regulation Crowdfunding is not conditioned upon compliance with the annual reporting, progress update or termination-of-reporting obligations. As the SEC indicated in the Regulation Crowdfunding adoption release, to adopt a contrary rule “would create substantial uncertainty for issuers because there would be an indefinite possibility of a potential future violation of the exemption.” Nevertheless, crowdfunding issuers are required to comply with the requirements and may be subjected to potential enforcement action by the SEC and other regulatory authorities for non-compliance.
In addition, as discussed in Part 1 of this Corporate Update, an issuer that has failed to file with the SEC any annual reports required during the two years immediately preceding the filing of an offering statement on Form C is prohibited from relying on the crowdfunding exemption for any offer or sale of crowdfunded securities until such time that they file, to the extent required, the two most recently required annual reports. An issuer must also disclose any non-compliance with these annual reporting obligations in a Regulation Crowdfunding offering statement.
Compared to a traditional private placement under Regulation D, the costs of compliance – particularly the preparation of the offering statement, necessary financial statements, as well as the ongoing reporting requirements –in relation to the maximum offering size, may impede wide-spread reliance on the new crowdfunding rules.