The Crowdfunding Proposed Rules
Crowdfunding means raising funds over the Internet for artistic, charitable and other ventures by seeking small individual contributions from a large number of people with input from the wisdom of the crowd. It has not so far been (legally) used by entrepreneurs to raise capital. The proponents of the Jumpstart Our Business Startups (JOBS) Act1 touted the law as a means to create jobs by deregulating the capital raising process for small business by, among other things, allowing entrepreneurs to use the Internet to sell stocks outside of the restrictions of the securities laws. Opponents of the JOBS Act recalled the pump and dump scams that occurred pursuant to the similar Rule 504 deregulated offerings in the 1990s2 and insisted that various investor protection provisions be added to the law.3 The result is an internally contradictory statute handed over to the Securities and Exchange Commission (SEC) to rationalize through rulemaking.
Those who hoped for an essentially regulation-free field where small business owners could use the Internet to attract investors will surely be disappointed. The SEC's crowdfunding rule proposals run on for 175 pages in the Federal Register PDF version, and have more than 1,000 footnotes and almost 300 requests for comments.4 The politicians and judges who have tried to put a halt to new federal regulations by imposing cost-benefit analyses on agencies and erecting other barriers to the rulemaking process, and who now favor a deregulatory rulemaking initiative, have been hoist by their own petards.
In its crowdfunding rules, the SEC adhered closely to the JOBS Act provisions expressing some hope that crowdfunding could lead to a new avenue for less expensive capital raising by small businesses than a registered offering, but put various investor protection mechanisms in place. As a technical matter, the SEC did a masterful job of constructing rules for crowdfunding offerings that fit into the general framework of the Securities Act of 1933 (Securities Act), but one cannot help wonder when final rules might be passed and whether anyone will use these rules to raise capital. The SEC engaged in a pre-rulemaking request for comment on crowdfunding. The controversial and conceptually difficult nature of these provisions generated a long list of commenters that runs for over three pages in the Federal Register.
There are a variety of provisions of the JOBS Act applicable to crowdfunding transactions in Title III of the JOBS Act, now incorporated into the Securities Act and the Securities Exchange Act of 1934 (Exchange Act). Section 4(a)(6) of the Securities Act provides an exemption from the registration requirements of the Securities Act for crowdfunding transactions with the following limitations: The amount raised cannot exceed $1 million in a 12-month period; individuals may not invest more than $2,000 or 5 percent of annual income or net worth, if their annual income or net worth is less than $100,000, or 10 percent of these amounts if their annual income or net worth is $100,000, but with an overall limit of $100,000; and transactions must be conducted through a broker-dealer or a "funding portal" (which is a limited broker-dealer).
Section 4A of the Securities Act requires issuers and intermediaries to provide certain information to potential investors and provide notices and other information to the SEC. Section 3(h) of the Exchange Act requires the SEC to exempt funding portals from broker-dealer registration. Section 15(a)(1) of the Exchange Act sets forth disqualification provisions for crowdfunding transactions. Section 12(g)(6) of the Exchange Act requires the SEC to adopt exemptions from Exchange Act registration requirements for issuers which have gone public through a crowdfunding transaction.
Section 4A(f) of the Securities Act provides that some issuers may not take advantage of crowdfunding, specifically, foreign issuers; Exchange Act reporting issuers; investment companies and hedge funds; and other issuers specified in SEC rulemaking. The SEC amplified these exclusions by adding "bad actor" disqualified issuers under Section 302(d) of the JOBS Act; issuers who have sold securities in crowdfunding transactions but did not thereafter file required annual reports with the SEC; and issuers with no specific business plan.5
The crowdfunding rules are divided into requirements for issuers and requirements for intermediaries. The requirements for issuers consist of disclosure rules for offerings and follow on annual reports and a few substantive rules designed to protect investors from being locked into offerings they wish to avoid after participating in the crowdfunding process. The former proposals are a simplified version of SEC disclosure requirements on a new Form C. The latter rules bear some resemblance to tender offer withdrawal rules.
The disclosure information for a crowdfunding offering must include: a description of the issuer's business and intended business plan; identification of officers, directors, and major shareholders; offering risk factors; target offering size and deadline for completion; price and description of securities offered; the issuer's capitalization including existing debt; intended use of proceeds; and compensation to be paid to the intermediary.6 A narrative discussion of the issuer's financial condition similar to the MD&A of Item 303 of Regulation S-K is also required.7
The required financial disclosure is tiered depending upon the amount of the offering. Issuers offering $100,000 or less are required to provide and file with the SEC income tax returns and financial statements certified by the issuer's principal executive. Issuers offering more than $100,000 are required to provide financial statements reviewed by an independent public accountant. Offerings of $500,000 or more require audited financial statements.8 All issuers would have to provide to intermediaries and investors and file with the SEC a complete set of financial statements prepared in accordance with GAAP for the two most recently completed fiscal years or (if shorter) since the inception of the issuer's business. Issuers must also provide regular updates on the issuer's progress in meeting its target amount.
The SEC determined not to require an issuer which has made a crowdfunding offering to register securities thereafter pursuant to Section 12(g) of the Exchange Act. In making this decision, the SEC seems to acknowledge that the metrics for determining whether a company is public are no longer relevant for many issuers. However, issuers which have sold securities in a crowdfunding transaction must adhere to annual reporting requirements essentially updating their initial crowdfunding offering materials.
Issuers are not permitted to advertise a crowdfunding offering except for a limited tombstone type of notice. Further an issuer is limited when compensating anyone for promoting the offering outside of the funding portal.9 Resales of securities purchased in a crowdfunding offering are restricted for one year. In reality, there may not be any resale after market. Oversubscriptions are allowed as long as an issuer describes how they will be handled. Any type of securities may be offered in a crowdfunding transaction, but the issuer must describe the terms of the securities and their valuation methodology.10