Yesterday, the Securities and Exchange Commission (the “SEC”) held an open meeting to approve the release of proposed crowdfunding rules implementing Title III of the 2012 Jumpstart Our Business Startups Act (the “JOBS Act”). Once the SEC adopts final implementing rules, the crowdfunding exemption contained in Section 4(a)(6) of the Securities Act of 1933 (the “Securities Act”) will allow U.S. private companies (primarily startups and small businesses) to raise up to $1 million in any 12-month period from pools of small investors without registration under the Securities Act. The fundraising will be required to be conducted through a registered intermediary—either a registered broker or an online “funding portal.” While the SEC missed the December 31, 2012 deadline to adopt implementing rules, it now appears to be moving ahead full speed with the proposed rulemaking.
The proposed rules address various topics relating to crowdfunding issuers, intermediaries and investors, in addition to posing 295 requests for comment. Comments are due 90 days from publication of the proposal in the Federal Register, which is expected in the next several days. The SEC staff (the “Staff”) also noted that FINRA is expected to issue a regulatory notice regarding its crowdfunding rules in the next few days.
Links to the proposing release (“Proposing Release”) and the Commission’s Fact Sheet summarizing the proposed rules are provided below:
We expect to issue a client alert in the near future that will contain more in-depth analysis of the Proposing Release and its potential implications.
The Staff noted that certain types of issuers will not be eligible to use crowdfunding. These include foreign issuers, existing public issuers, investment companies, issuers who have failed to file an annual report in accordance with the proposed rules, issuers with no specific business plan or that exist solely to facilitate mergers with unidentified entities, and issuers that are disqualified under proposed disqualification rules, which are substantially similar to the “bad actor” disqualification provisions that apply to offerings relying on Rule 506 of Regulation D. In the event there are “insignificant deviations” from the crowdfunding rules, issuers may be able to avail themselves of a proposed safe harbor that would enable them to maintain their crowdfunding exemption.
The proposed rules would mandate that issuers disclose certain information to investors and the SEC, both in the context of a proposed securities offering and as part of their ongoing reporting obligations. When offering securities, issuers would need to disclose information about their officers, directors and 20% or greater owners, the terms of the proposed offering (including target offering amount and deadline to reach that sum and whether the issuer will accept investments in excess of the target amount), use of proceeds, related party transactions, and descriptions of the issuer’s business and financial condition. Prior to completion of an offering, progress reports towards the issuer’s target offering amount would be required, and annual reporting would be required after completion of a crowdfunding offering.
Issuers would also be required to provide financial statements prepared in accordance with U.S. GAAP covering the shorter of the issuer’s two most recent fiscal years or the period since the issuer’s inception. Financial statements will reflect a sliding scale of certification, review or audit depending on the amount of capital the issuer proposes to raise. If $100,000 or less, then certification by the issuer’s principal executive officer would be required, in addition to providing the issuer’s income tax returns to investors, relevant intermediaries and the SEC. If the offering is for an amount greater than $100,000 and up to $500,000, the proposed rules would require financial statements that have been reviewed by the issuer’s independent accountants. For offerings over $500,000, audited financial statements would be required.
Regulation of Crowdfunding Intermediaries
The Proposing Release includes rules governing crowdfunding intermediaries, including both the new online “funding portals” called for by the JOBS Act and registered brokers. These regulated intermediaries would be required to provide investors with educational materials and information regarding the issuer and its offering, including risks associated with crowdfunding investments. Intermediaries would also be required to take certain steps to reduce the risk of fraud and provide communication channels to permit discussions regarding an offering (presumably in line with the theory that the “wisdom of the crowd” can help identify and fund good investments). Officers, directors and partners of an intermediary would be prohibited from having any financial stake in any issuer using their services. The proposed rules also provide for disqualification of intermediaries in certain circumstances under conditions that are somewhat broader than Rule 262 of Regulation A under the Securities Act.
Online crowdfunding portals would be entrusted with facilitating crowdfunding offerings, but may solely act as intermediaries and may not otherwise handle customer funds, offer investment advice or recommendations, solicit investments or compensate employees, agents or other persons to do so. Funding portals would be subject to oversight by the SEC and FINRA, and would be required to file a Form Funding Portal with the SEC. The proposed rules contemplate a conditional safe harbor under which funding portals could engage in certain activities in connection with their services as intermediaries without violating statutory provisions or the crowdfunding rules. In addition, while the Proposing Release permits funding portals to be foreign entities, these entities would be required to register with the SEC and FINRA and would be subject to on-site examination by the SEC.
Under the proposed rules, the amount of securities that may be sold to an investor over a 12-month period is limited based on an investor’s annual income and net worth. For an investor with an annual income and net worth of less than $100,000, the investor’s maximum aggregate annual investment is capped at the greater of $2,000 or 5% of such investor’s annual income or net worth, whichever is greater. For investors with an annual income or net worth over $100,000, such investments are capped at the lesser of $100,000 or 10% of such investor’s annual income or net worth, whichever is greater. A natural person’s net worth would be calculated in accordance with the SEC’s accredited investor rules, which exclude the value of the person’s primary residence.
Commissioner Stein specifically noted the request for comment in the Proposing Release regarding the limitation based on the “greater of” an investor’s annual income or net worth in light of ambiguity in the statute, because the proposed reading of the statute could have the effect of increasing an investor’s individual investment limit .
Requests for Comment
Commissioners and Staff alike emphasized that they wished to receive feedback from the investment community and from investor groups on the proposed rules, and Chair White indicated that the Staff will monitor the use of crowdfunding once effective to ensure that investors are being adequately protected and to understand how use of the exemption evolves over time.
Commissioners Stein and Aguilar each expressed some concern that investors may not be adequately protected, with Commissioner Aguilar stressing his concern regarding the potential for fraud in low income or other disadvantaged communities. Commissioner Aguilar called upon the SEC to monitor the development of these issues and to closely coordinate with state regulators as appropriate. Commissioner Stein also specifically requested comment on whether cost-effective third-party intermediaries, such as a transfer agent, should be required to keep lists of security holders (rather than issuers themselves) to ensure compliance with record-keeping requirements.