By Andrew J. Merken & Josef B. Volman
On Oct. 30, 2015, the Securities and Exchange Commission (“SEC”) adopted new rules that will enable some private companies to use the Internet for crowdfunding campaigns seeking up to $1 million per 12-month period.
The rules exempt crowdfunding offerings from traditional securities registration requirements under specific conditions to facilitate capital formation by smaller and startup companies. The SEC adopted the rules pursuant to the requirements of the Jumpstart Our Business Startups Act (“JOBS Act”). The SEC previously proposed crowdfunding rules in October 2013 as outlined in our advisory.
The aptly named “Regulation Crowdfunding” rules will be effective May 16, 2016, but forms for registration of funding portals will be effective Jan. 29, 2016. The SEC published the lengthy (685 pages) rules and related analyses in SEC Release No. 33-9974; 34-76324.
The new crowdfunding rules place significant SEC and FINRA filing and compliance requirements on companies looking to raise a relatively small amount of funding, and on the funding portals/broker-dealers through which the offerings will be conducted.
When the rules were first proposed in 2013, questions arose as to how many companies would avail themselves on the new rules once they were issued and effective. It may be that the burdens are too significant for many companies who could choose to utilize the traditional Regulation D Rule 506 private placements, including the newer Rule 506(c), which does allow certain types of general solicitation and advertising but for sales to accredited investors only. Continue reading for a deeper look at some of the key provisions.
For any exempt crowdfunding transaction, an issuer must use an intermediary – either a registered broker-dealer or funding portal – and can use only one intermediary at a time. The transaction will have to be conducted exclusively on the intermediary’s online platform.
Many issuers are excluded from utilizing Regulation Crowdfunding, including the following issuers:
Rule 100(a) of Regulation Crowdfunding limits the aggregate amount sold by an issuer to all investors in reliance on the new exemption (in one or more offerings) to not more than $1 million in the 12-month period preceding the date of sale. Any capital the issuer raises through other exempt transactions, such as Regulation A or Regulation D offerings, will not be counted in determining the aggregate amount sold.
Under the final rules, an investor’s maximum purchase in a crowdfunding offering will be the greater of:
For example, under this approach, an investor with annual income of $50,000 and a net worth of $105,000 is subject to an investment limit of $2,500 (five percent of annual income). The existing Securities Act Rule 501(a) applicable to determining accredited investor status will govern the calculation of net worth and annual income.
The final rules require crowdfunding issuers to file certain information with the SEC and provide it to investors and the relevant intermediary for an offering. The required disclosures include, among other things:
An issuer is required to amend its offering documents within five (5) business days of any material change to disclose material changes that occurred during the offering period and to provide specified updates regarding progress (including 50 percent and 100 percent commitments) toward reaching the target offering amount.
The issuer’s information must be posted on the intermediary’s platform for at least 21 days prior the sale of any securities (though investment commitments can be accepted) and throughout the entire offering period.
The final rules also require issuers to file with the SEC and electronically deliver to investors ongoing annual reports (Form C-AR) of the results of operations and relevant financial statements. The level of review of the financial statements will depend on the aggregate amount of securities offered by the issuer during the prior 12 months, including the current offering. They will have to be either certified by the issuer’s principal executive officer or prepared, reviewed or audited by an independent public accountant and filed no later than 120 days after the fiscal year covered by each report. However, quarterly reports or current reports as would be reported on an 8-K are not required.
By statute and rule, all crowdfunding transactions will need to be conducted through a broker or funding portal. To be exempt from broker registration, funding portals must register with the SEC and FINRA. To maintain exempt status, funding portals must refrain from offering investment advice, soliciting transactions on the portal, handling investor funds or engaging in other activities proscribed by the SEC.
The final rules, unlike the proposed rules, will permit an intermediary to take a financial interest in a crowdfunding issuer but only if the interest is a form of compensation for crowdfunding services to the issuer and consists of the same securities being offered to others. Intermediaries will not be allowed to compensate any person for providing personally identifiable information about crowdfunding investors.
Rule 301(a) will require an intermediary to have a reasonable basis for believing that a crowdfunding issuer is in compliance with statutory and regulatory mandates associated with Regulation Crowdfunding, including record-keeping requirements.
An intermediary will be allowed to reasonably rely on representations of compliance from the issuer, unless the intermediary has reason to question the reliability of those representations. If an issuer has engaged the services of a transfer agent in an offering, the intermediary will be deemed to have a reasonable basis for assuming that adequate record- keeping compliance measures were taken.
If an intermediary has a reasonable basis for believing that an issuer or certain affiliated persons are subject to disqualification, the intermediary must deny the issuer access to its crowdfunding platform.
The rules will also require an intermediary to perform certain account opening duties, supply the SEC and investors with offering statement and disclosure information via electronic delivery, and provide on its platform effective channels for communication among investors and representatives of the issuer. An intermediary will also be required to give investors specific types of notices about an offering and a purchaser’s rights in association with confirmations, cancellations and reconfirmations of securities purchases. Certain record-keeping and compliance rules will apply to an intermediary as well.
An intermediary for a crowdfunding offering will have to register with the SEC as either a broker or a funding portal. The SEC is providing a streamlined process for registration of funding portals that is consistent with but less extensive than the process for broker-dealer registration.
A new Form Funding Portal will require information related to ownership and control of the portal, escrow and compensation arrangements, prior litigation, disciplinary history and other specified items. But unlike the proposed rules, the final rules will not require funding portals to have a fidelity bond.
Rule 402 of Regulation Crowdfunding provides a non-exclusive conditional safe harbor for certain specified activities of funding portals in connection with crowdfunding offerings.
For example, the safe harbor rule will allow funding portals to highlight multiple offerings according to specified objective and searchable criteria. The search criteria specifically cannot include any kind of investment opinion or analysis, management assessment or risk analysis. Funding portals will also be allowed to supply but not participate in channels for investor and issuer communications under specified conditions that will insure fair, open and transparent communications.
The SEC will provide a safe harbor for a funding portal to advertise its existence and identify its offerings under specified conditions, and it will allow a portal to advise issuers about the structure or content of an offering, and help issuers prepare offering documents.
Portals will also be allowed to pay third parties for referring a person to them, so long as the third parties do not provide personally identifiable information and the compensation is not based on a security transaction being completed. Under specified circumstances, a funding portal can pay for the services of registered broker or dealer in connection with a crowdfunding offering.
Securities issued in a crowdfunding transaction will not be transferable by an original purchaser for a one-year period unless transferred to the issuer, an accredited investor, a family member, certain related trusts, or as part of a registered offering.
Advertising the terms of the offering is not permitted, except for limited tombstone-type ad notices that direct potential investors to more information about the offering on the funding portal/broker-dealer’s platform. These are similar to the tombstones permitted under Securities Act Rule 134. However, the rules do not prohibit how the notices can be distributed, so an issuer could place its notice in newspapers, as well as on social media sites and its own website.
The rules will impose “bad actor” disqualifications that are aligned with the disqualifications applicable under other exempt offerings. Legal persons covered by the bad actor rules include the issuer and its predecessors or affiliates, the intermediary, specified control persons, certain promoters, compensated solicitors and their control persons (“Covered Persons”).
Covered Persons involved in a disqualifying event, such as securities fraud or postal fraud, will not be allowed to play a role in, benefit from or conduct a crowdfunding offering. Though an issuer will not lose the benefit of a crowdfunding exemption if it is able to show that it did not know and with reasonable diligence could not have known of the existence of a disqualification. Disqualified persons can also seek a waiver of disqualification for equitable reasons.
Crowdfunding offerings are not required to conform to state registration/”blue sky” requirements, which are preempted by the SEC rules.