The crowdfunding rules have finally arrived. 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 the opportunity to raise capital in a more cost-effective manner. In this update, Part 1 of a three-part series, we will provide an overview of Regulation Crowdfunding. In Part 2, we will discuss the disclosure requirements applicable to issuers conducting a crowdfunded offering. In Part 3, we will outline the role and obligations of intermediaries. The Regulation Crowdfunding adopting release is available here.
What is crowdfunding?
Crowdfunding is a method of raising funds on the internet to support various ventures, with the fundraiser typically seeking to raise small amounts from a large number of investors. Those who are interested in contributing funds often share information about the venture with each other and rely on the collective wisdom of the crowd in deciding whether to participate.
When are the new rules effective?
The new rules will be effective 180 days after publication in the Federal Register, but the forms permitting funding portals to register with the SEC will be effective January 29, 2016.
Why couldn’t an issuer engage in crowdfunding before Regulation Crowdfunding?
To date, crowdfunding in the United States has typically not involved an offer to share in the revenues or profits of a business venture since such offer would likely involve the offer and sale of a security under U.S. federal and state securities laws and would need to be registered under, or exempt from, such securities laws. Limitations under existing private placement exemptions, including (i) the prohibition on general solicitation and advertising under Rules 505 and 506(b) of Regulation D and (ii) although permitting general solicitation and advertising, the requirement under Rule 506(c) of Regulation D that sales be made only to accredited investors, have prevented crowdfunding of securities since crowdfunding tends to involve a large number of unsophisticated, unaccredited investors that need to be contacted through general solicitations or advertisements. Furthermore, prior to Regulation Crowdfunding, the operator of an internet website that facilitates the purchase and sale of securities for the account of others would generally be required to register as a broker-dealer and comply with U.S. federal and state broker-dealer laws. Such compliance was typically uneconomical for a website operator catering to startups and small businesses.
How does Regulation Crowdfunding permit securities crowdfunding?
Regulation Crowdfunding provides a regulatory framework to address these issues. In particular, Regulation Crowdfunding: (i) permits individuals to invest in securities of an issuer, subject to certain investment limitations, (ii) caps the funds that may be raised by an issuer under crowdfunding at $1 million in a 12-month period, (iii) requires issuers to disclose certain information about their business and offerings, including in an offering statement and annual reports, and (iv) provides a regulatory framework for registered brokers and funding portals (called “intermediaries”) that operate the crowdfunding platform or otherwise facilitate the crowdfunding.
What issuers are eligible to conduct a crowdfunding offering?
An issuer must be organized under, and subject to the laws of a state or territory of the United States or the District of Columbia. The SEC concluded that non-U.S. issuers may present unique risks that would make them unsuitable for the scaled regulatory regime associated with crowdfunding.
In addition, such issuer must not:
- be subject to the reporting requirements of Section 13 or Section 15(d) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”);
- be an “investment company” under the Investment Company Act of 1940, as amended, or excluded from such definition under Section 3(b) or 3(c) of such act;
- be subject to any disqualification event under Rule 503(a) of Regulation Crowdfunding (which events are substantially similar to the existing “bad actor” disqualification events with respect to Rule 506 of Regulation D);
- have sold securities in reliance on the crowdfunding exemption and failed to file with the SEC and provide to investors any ongoing annual reports required by Regulation Crowdfunding during the two years immediately preceding the filing of the required crowdfunding offering statement (as discussed below); and
- lack a specific business plan or indicate that its business plan is to engage in a merger or acquisition with an unidentified company.
How much can an issuer raise under the exemption and how much can an investor invest?
The crowdfunding exemption is subject to the following limitations:
- the aggregate amount of securities sold to all investors in reliance on the crowdfunding exemption during the 12-month period before the date of a given offer or sale must not exceed $1,000,000 (including the amount of securities offered in the proposed crowdfunding transaction);
- the aggregate amount of securities purchased by any individual investor across all issuers relying on the crowdfunding exemption during the 12-month period before the date of a given offer or sale must not exceed (inclusive of any securities sold to the investor in the proposed crowdfunding transaction):
- if the investor’s annual income or net worth is less than $100,000: the greater of (x) $2,000 or (y) 5 percent of the lesser of such investor’s annual income or net worth; or
- if both of the investor’s annual income and net worth are equal to, or greater than, $100,000: 10 percent of the lesser of such investor’s annual income or net worth, which amount cannot exceed $100,000.
Each investor’s annual income and net worth are calculated in the manner required to determine accredited investor status under Rule 501 of Regulation D; under this rule, a person’s primary residence is not included as an asset. In addition, an investor’s annual income and net worth may be calculated jointly with his or her spouse, so long as the aggregate investment of both spouses does not exceed the limit that would apply to an individual investor at the same income or net worth level.
For purposes of determining whether the aggregate amount of securities purchased by an investor would not cause such investor to exceed the investment limits, the issuer can rely on efforts the intermediary is required to undertake, so long as the issuer does not have knowledge that the investor has exceeded, or will exceed, the investment limits.
Does this exemption limit an issuer’s ability to rely on a different securities exemption, such as Regulation D?
No. The SEC is of the view that an offering conducted in reliance on Regulation Crowdfunding should not be integrated with another exempt offering made by the issuer so long as each offering complies with the requirements of the applicable exemption that is being relied upon for the particular offering.
Are there disclosure requirements?
Yes. An issuer offering or selling securities under Regulation Crowdfunding must prepare a relatively detailed offering statement for the proposed crowdfunding transaction describing the offering and its business and including financial statements. To assist in the preparation of the offering statement, the SEC has also provided a streamlined Q&A version of an offering statement in clear language as part of the adopted Form C. In Part 2 of this Corporate Update, we will discuss these disclosure requirements in detail.
Prior to commencement of the offering, the issuer must file the offering statement with the SEC on Form C and provide a copy to the intermediary and the investors.
Any amendments to the offering statement must be filed with the SEC and provided to the intermediary and investors. If the amendment includes material changes, the investors must reconfirm their investment commitment within five business days or such investor’s commitment will be considered cancelled.
The issuer must also disclose, through a Form C-U filing with the SEC, its progress 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 Form C-U filing 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.
Are there ongoing reporting obligations?
Yes. One of the more significant aspects of the new rules, and potential drawbacks of relying on the crowdfunding exemption, is the ongoing annual reporting obligations of crowdfunded issuers. Issuers must file with the SEC an annual report, which includes substantially the same information as the offering statement (excluding certain information relating to the offering and with more relaxed financial statement requirements), within 120 days after the end of the fiscal year covered by the report. The annual report must also be posted on the issuer’s website.
Can the issuer advertise?
Advertising relating to the terms of an offering is limited under Regulation Crowdfunding. In particular, an issuer, and persons acting on its behalf, may not advertise the “terms of an offering” (i.e., the securities offered, the nature of the securities, the price of the securities and the closing date of the offering period) made in reliance on the crowdfunding exemption, unless it directs investors to the intermediary’s platform and includes only the following information:
- a statement that the issuer is conducting an offering pursuant to the crowdfunding exemption, the name of the intermediary involved and a link to the intermediary’s platform;
- the terms of the offering; and
- factual information about the legal identity and business location of the issuer, limited to the name of the issuer, the address, phone number and website of the issuer, the email address of a representative of the issuer and a brief description of the business of the issuer.
An issuer is not limited as to where it can distribute the permitted notices and may, for example, post such notices on social media sites or the issuer’s own website. An issuer is not prevented from communicating other information that might occur in the ordinary course of its operations and does not refer to the terms of the offering.
An issuer may also communicate with investors about the terms of the offering through the intermediary’s platform as long as the issuer identifies itself as the issuer. (Persons acting on behalf of the issuer must similarly identify their affiliation with the issuer, and disclose the receipt of compensation for communications, in all communications on the intermediary’s platform.)
Can an investor change their mind about the investment?
Yes. An investor may cancel an investment commitment for any reason until 48 hours before the offering deadline indicated in the offering statement. During the 48 hours before such deadline, the commitment may only be cancelled if there is a material change to the terms of the offering or to the information provided by the issuer.
How long must the offering last?
A crowdfunded offering must be open for a minimum of 21 days.
What if the offering is completed before the deadline?
If the issuer meets the target offering amount before its offering deadline, the issuer may close the offering early, as long as:
- the offering remains open for a minimum of 21 days;
- the intermediary provides notice to any investors or potential investors alerting them to (i) the new deadline, (ii) their right to cancel commitments until 48 hours prior to the new deadline and (iii) whether the issuer will accept commitments during the 48 hours prior to the new deadline;
- the new deadline is at least five business days after the above notice is given to investors and potential investors; and
- at the time of the new deadline, the issuer continues to meet the target offering amount.
What if the terms of the offering change?
If there is a material change to the terms of an offering or to the information provided by the issuer, then Regulation Crowdfunding requires the intermediary to send to any investor who has made a commitment a notice (i) describing the material change and (ii) that the investment will be cancelled unless the investor reconfirms his or her investment within five business days. If the material change occurs within five business days of the offering deadline, the offering must be extended to allow five business days for the investor to reconfirm.
What if the issuer doesn’t complete the offering?
If the target offering amount is not reached by the offering deadline or the issuer does not otherwise complete the offering, the intermediary must send notification of cancellation to each investor and direct a refund of investor funds within five business days.
Are there any restrictions on resales of stock sold in a crowdfunding?
Yes. Securities issued pursuant to the crowdfunding exemption may not be transferred by any purchaser (including any subsequent purchaser) of such securities within the one-year period beginning on the original issue date, unless such securities are transferred:
- to the issuer of the securities;
- to an accredited investor (as defined in Rule 501 of Regulation D);
- as part of an SEC-registered offering; or
- to a family member of the purchaser, trust controlled by the purchaser, trust created for the benefit of a family member or in connection with the death or divorce of the purchaser or other similar circumstance.
Will the issuer become subject to the reporting requirements of the Exchange Act if it sells to a high number of investors?
Included in Regulation Crowdfunding is new Exchange Act Rule 12g-6. Given the potentially large number of investors in a typical crowdfunding transaction, this rule provides that securities issued pursuant to the crowdfunding exemption are exempted from the record holder count under Section 12(g) of the Exchange Act (which would require registration of a class of equity securities if held of record by either 2,000 persons or 500 persons who are not accredited investors, subject to satisfaction of a total asset test), so long as the issuer:
- is current in its ongoing annual reports required pursuant to Regulation Crowdfunding;
- has total assets as of the end of its last fiscal year not in excess of $25 million; and
- has engaged the services of a registered transfer agent.
Any issuer that exceeds that $25 million threshold (and exceeds the 2000- or 500-person thresholds in Section 12(g)) will be granted a two-year transition period before it will be required to register its class of securities pursuant to Section 12(g), as long as it timely files all of its ongoing reports under Regulation Crowdfunding.
Can the issuer conduct a crowdfunded offering on its own?
No. To take advantage of the crowdfunding exemption, the issuer must use the platform of an intermediary, which must be (i) a registered broker under Section 15(b) of the Exchange Act or (ii) a funding portal in accordance with Regulation Crowdfunding, and, in either case, a member of FINRA. A “funding portal” is defined in Regulation Crowdfunding to mean a broker acting as an intermediary in a transaction involving the offer or sale of securities in reliance on the crowdfunding exemption, subject to certain restrictions on its activities. Funding portals must be registered with the SEC. In Part 3 of this Corporate Update, we will discuss intermediaries in more detail.
What about issuer and intermediary liability to investors in a crowdfunding transaction?
An issuer is liable to a crowdfunding investor if the issuer makes an untrue statement of a material fact or omits to state a material fact required to be stated or necessary in order to make the statements, in light of the circumstances under which they were made, not misleading, so long as:
- the purchaser did not know of such untruth or omission; and
- the issuer does not sustain the burden of proof that it did not know, and in the exercise of reasonable care could not have known, of such untruth or omission.
The definition of “issuer” in this context includes “any person who offers or sells the security in such offering,” which the SEC has concluded encompasses intermediaries such as funding portals. In its adopting release, the SEC specifically noted the defense available to intermediaries (and the issuer) relating to the exercise of reasonable care and suggested that there were “appropriate steps” that intermediaries might take to exercise such reasonable care including “establishing policies and procedures that are reasonably designed to achieve compliance with the requirements of Regulation Crowdfunding, and conducting a review of the issuer’s offering documents before posting them to the platform to evaluate whether they contain materially false or misleading information.”
Does this provide an exemption from state law?
States are preempted from regulating certain aspects of crowdfunding conducted in accordance with the new rules, including state registration, documentation and offering requirements with respect to crowdfunded securities. In addition, no notice filings and fees may be required with respect to offers and sales of crowdfunded securities except as may be required by the securities commission of the state of the principal place of business of the issuer or any state in which purchasers of 50 percent or greater of the aggregate amount of the issue are residents.
The JOBS Act did not, however, limit the states’ authority to take enforcement action with regard to an issuer, funding portal or other person engaged in crowdfunding. Form C will require the issuer to indicate the jurisdictions in which it intends to offer the securities, which will facilitate antifraud oversight by state regulators.
Regulation Crowdfunding was finally adopted by the SEC over three years after the JOBS Act mandated their promulgation and two years after the SEC’s proposed rules (and after the SEC’s review of over 485 comment letters relating thereto). It has the potential to enhance capital formation among startups and small businesses. How it plays out may take some time as the rules go into effect and issuers and potential funding portals consider the costs and benefits of utilizing the new regime.
In particular, it remains to be seen:
- whether issuers will take advantage of the new crowdfunding exemption given the costs of compliance – particularly the preparation of the offering statement and necessary financial statements, as well as the ongoing requirement to file annual reports with much of the same mandated disclosure included in the initial offering statement – relative to the $1 million cap on raises;
- whether a robust network of funding portals will develop given their exposure to statutory liability and the onerous and costly regulatory requirements;
- whether the crowdfunding regulatory safeguards, including the ability to bring private suits against funding portals, will prophylactically work to minimize fraud against unsophisticated investors by issuers with limited operating histories; and
- whether investors will respond negatively to the one-year holding requirement for crowdfunded securities.