On October 23, 2013, the Securities and Exchange Commission (the “SEC”) proposed rules under the Jumpstart Our Business Startups Act (the “JOBS Act”) to permit companies to offer and sell securities through crowdfunding.1 Historically, because offers and sales of securities to the public generally require compliance with the registration requirements of the Securities Act of 1933 (the “1933 Act”), crowdfunding has been restricted to non-securities matters, for example, to solicit donations. Under the SEC’s proposed rules, Section 4(a)(6) of the 1933 Act will be a new registration exemption available for crowdfunding offerings under certain conditions.
The Proposed Rules
As proposed, a company may raise investment capital through crowdfunding if certain conditions, including the following, are met:
- A company raises no more $1 million through crowdfunding offerings in a 12-month period;
- Over the course of a 12-month period, each of the company’s investors has invested no more than the following in all offerings relying on the crowdfunding exemption:
- $2,000 or 5 percent of their net worth or annual income, whichever is greater, if both their net worth and annual income are less than $100,000; or
- 10 percent of their net worth or annual income, whichever is greater, not to exceed a maximum aggregate amount $100,000 invested, if either their net worth or annual income is equal to or more than $100,000;
- The transaction is conducted exclusively through a single qualifying intermediary’s2 platform; and
- The company complies with the requirements of the exemption.
Crowdfunding offerings must be conducted exclusively online through a platform operated by a registered broker or a funding portal.3 Under the proposed rules, these intermediaries must:
- Have a reasonable basis for believing that the company is complying with the applicable rules;
- Provide investors with educational materials;
- Ensure that the company’s disclosure is made publicly available for 21 days before securities are sold;
- Make available information about the company and the offering;
- Facilitate the offer and sale of crowdfunded securities;
- Take measures to reduce the risk of fraud;
- Provide communication channels to permit discussions about offerings on the platform; and
- Avoid offering investment advice or making recommendations.
The proposed rules require a company conducting a crowdfunding offering to file an offering statement with the SEC through the EDGAR filing system on a new Form C and to provide the offering statement to investors and the relevant intermediary facilitating the crowdfunding offering. Items that the company will be required to disclose in its offering documents include:
- A description of the company’s business and the use of proceeds from the offering;
- The price to the public of the securities being offered, the target offering amount, the deadline to reach the target offering amount, and whether the company will accept investments in excess of the target offering amount;
- Information about the risks of the offering;
- Information about officers, directors and owners of 20 percent or more of the company;
- Certain related-party transactions; and
- A description of the financial condition of the company including for offerings that, together with all other crowdfunding offerings of the company within the preceding 12-month period, have in the aggregate, target offering amounts of:
- $100,000 or less: (a) the income tax returns filed by the company for the most recently completed year (if any); and (b) financial statements of the company, which shall be certified by the principal executive officer of the company to be true and complete in all material respects;
- more than $100,000, but not more than $500,000: financial statements reviewed by an independent public accountant using professional standards and procedures for such review or standards and procedures established by the SEC by rule for such purpose; and
- more than $500,000 (or such other amount as the SEC may establish by rule): audited financial statements.
The proposed rules require the offering statement to be updated for material events over the course of the offering prior to completion, and provide investors with the option to back out of their investment in such an event.
A company relying on the crowdfunding exemption will also be required to file an annual report with the SEC and post it on their website, which would include updates of many of the items included in the initial offering statement.
Companies must also clearly disclose all compensation paid directly or indirectly to solicitors that promoted the offering through the channels of the broker-dealer or funding portal.
Companies that are ineligible to use the crowdfunding exemption include companies that already are SEC reporting companies, foreign companies, companies that are disqualified under the proposed disqualification rules, companies that have failed to comply with the annual reporting requirements in the proposed rules, certain investment companies, and companies that have no specific business plan or have indicated that their business plan is to engage in a merger or acquisition with an unidentified company or companies.
Companies cannot advertise the terms of the offering, except for notices which direct investors to the funding portal or broker-dealer.
As stipulated in Title III of the JOBS Act, securities purchased in a crowdfunding transaction cannot be resold for a period of one year.
Holder of Record
Holders of these crowdfunding securities will not count toward the threshold that requires a company to register with the SEC under Section 12(g) of the Exchange Act.
Preemption of State Securities Laws
The crowdfunding exemption preempts state securities laws by making exempt crowdfunding securities “covered securities”, although some state enforcement authority and notice filing requirements would be retained. State regulation of funding portals will also be preempted, subject to limited enforcement and examination authority.
Initial Reaction to the Proposed Rules
The financial and compliance burdens imposed on crowdfunding offerings may make it impractical and prohibitively expensive for start-up companies to benefit from them, although the SEC’s proposed rules are intended to make it easier for start-up companies to raise capital. In addition to the costs that start-up companies will incur to prepare financial statements, engage and compensate a broker-dealer or funding portal and prepare disclosure materials, these companies will be required to regularly file financial and informational reports that will be available for review by the general public, including competitors, customers and strategic partners. A company will need to weigh the benefits of raising a limited amount of capital through crowdfunding against the financial and compliance obligations associated with the proposed crowdfunding rules, especially if the company is otherwise able to raise capital from “accredited investors” under the recently relaxed general solicitation and general advertising rules under Regulation D.
The SEC is seeking public comment on the proposed rules until approximately January 21, 2014. The SEC will then review the comments and determine whether to adopt the proposed rules. Until the SEC adopts final rules, the crowdfunding exemption contemplated by Section 4(a)(6) of the 1933 Act is not available.
Please contact Mitchell C. Littman, Esq. at email@example.com or Steven D. Uslaner, Esq. at firstname.lastname@example.org if you have questions concerning the proposed rules.
1Crowdfunding is the process of seeking relatively small investments from a broad group of investors via the Internet.
2An intermediary is either a broker-dealer or a funding portal registered with the SEC.
3A funding portal is defined as an intermediary for exempt crowdfunding offerings that does not: offer investment advice or recommendations; solicit purchases, sales, or offers to buy securities offered or displayed on its website or portal; compensate employees, agents, or other persons for such solicitation, or based on the sale of securities displayed or referenced on its website or portal; hold, manage, possess, or otherwise handle investor funds or securities; or engage in other activities as the SEC may determine. Funding portals are required to register with the SEC using Form Funding Portal, a modified Form BD, and to become members of the Financial Industry Regulatory Authority (“FINRA”).