Below is an article that I wrote for Business Law Today, a publication for the American Bar Association’s Business Law Section.
Crowdfunding: Its Practical Effect May Be Unclear Until SEC Rulemaking is Complete
President Obama signed the Jumpstart Our Business Startups Act (known as the JOBS Act) into law on April 5, 2012. One highly anticipated provision of the JOBS Act, Title III, is entitled ”Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act of 2012” or the ”CROWDFUND Act.” Title III enables “crowdfunding,” or the ability to sell securities in small amounts to a large number of investors.
Whether or not the crowdfunding provisions will have a significant impact on small business fundraising is yet to be determined. Despite the buzz among entrepreneur communities, various restrictions may make crowdfunding impractical for companies raising money and the intermediaries that facilitate the process. Most importantly, the crowdfunding provisions of the JOBS Act are not yet effective. On April 23, 2012, the SEC published guidance reminding issuers that “any offers or sale of securities purporting to rely on the crowdfunding exemption would be unlawful under federal securities laws” until the SEC adopts new rules.
Crowdfunding Prior to the JOBS Act
Crowdfunding is not a new concept. The Internet has made it easier for individuals and organizations to raise money for charitable purposes, political campaigns, artists seeking support from fans and various other projects. In 2005, Kiva launched a micro-finance platform that allows people to lend small amounts of money to entrepreneurs in developing areas. This lending model was further refined, and peer-to-peer lending companies like Prosper emerged in 2006 and Lending Club emerged in 2007. More recently, companies like Kickstarter have emerged to enable the public to fund creative projects ranging from independent films, video games, and food projects.
Prior to the JOBS Act, crowdfunding suffered from some several legal limitations. First, crowdfunding involving the sale of securities triggers the prohibitively expensive registration requirements of the Securities Act of 1933, as generally no exemptions are available in many crowdfunding models. Second, websites that facilitate crowdfunding may be subject to regulation as brokers.
As a result, current crowdfunding platforms have generally developed business models designed to avoid characterization as a sale of a security. Some companies utilize pure donation models. Companies like Kiva that provide micro-loans without interest and do not take commissions are arguably not offering securities because there is no expectation of profit on the part of the investors. Other companies like Kickstarter offer rewards or facilitate the pre-purchase of products. At the other extreme, because the SEC has taken the position that interest-bearing notes are securities, companies like Prosper and Lending Club have registered their offerings with the SEC.
Under pressure from Congress, the SEC agreed to review its regulations and their effect on capital formation in spring 2011. Crowdfunding received a boost when the Obama administration endorsed crowdfunding in September 2011. Although the SEC has the authority to exempt crowdfunding from the registration requirements of the Securities Act and to exempt intermediaries from registration as broker-dealers, Congress has forced the SEC to take action. The House of Representatives passed a crowdfunding bill in November 2011 and crowdfunding bills were introduced in the Senate in November 2011 and December 2011 that resulted in the crowdfunding provisions of the JOBS Act.
Crowdfunding Under the JOBS Act
Title III of the JOBS Act amends Section 4 of the Securities Act by adding a new paragraph (6), and requires the SEC to promulgate related rules to create an exemption from registration that permits a private company to sell securities in small amounts to large numbers of investors that are not accredited over a 12-month period.
Under the crowdfunding provisions, the aggregate dollar amount of securities that an issuer can sell in a crowdfunding transaction is limited to $1 million (less the aggregate amount of securities sold under other exemptions) over a 12-month period. In addition, the amount an issuer can sell to an individual investor in any 12-month period is limited to the maximum of:
• the greater of $2,000 or 5 percent of the annual income or net worth of an investor, if either the investor’s net worth or annual income is less than $100,000; and
• 10 percent, not to exceed $100,000, of annual income or net worth of an investor, if either the investor’s annual income or net worth is equal to or greater than $100,000.
Securities sold pursuant to the crowdfunding provisions are not transferable by the purchaser for one-year from the date of purchase, unless the securities are transferred to the issuer, an accredited investor, in a registered offering, or to family of the purchaser. The securities may also be subject to such other limitations as may be determined by the SEC.
Requirements on Intermediaries
An issuer must sell the securities in a crowdfunding offering through a broker or funding portal, which is required to register with the SEC and other applicable self-regulatory organizations.
These intermediaries need to meet a series of specific and restrictive requirements to be determined by the SEC. For example, intermediaries will be required to:
• provide investors with certain information (such as disclosures related to risks and other investor education materials);
• ensure that investors review the investor-education information, affirm their understanding of the risks and answer questions demonstrating an understanding of the risks;
• take measures to reduce the risk of fraud, including conducting background checks on officers, directors, and holders of more than 20 percent of the shares of issuers;
• make available to the SEC and potential investors the disclosure required to be provided by issuers not later than 21 days prior to the first day on with securities are sold;
• ensure that offering proceeds are provided to the issuer only when the target offering amount is reached or exceeded and allow investors to cancel their commitments;
• ensure that no investor in a 12-month period has purchased securities pursuant to the crowdfunding exemption that exceed the per-investor limits in the aggregate;
• take steps to ensure the privacy of information collected from investors;
• not compensate promoters, finders, or lead generators for providing the intermediary with the personal identifying information of any potential investor; and
• prohibit its directors, officers, or partners from having a financial interest in an issuer using its services.
The SEC is directed to establish rules that exempt funding portals from broker-dealer registration as long as they are subject to the authority of the SEC, are a member of a national securities association and are subject to other requirements the SEC may establish.
However, in order to qualify as a funding portal, the intermediary must not offer investment advice or recommendations; solicit purchases, sales, or offers to buy the securities offered on its website; compensate persons for such solicitation based on the sale of securities referenced on its website; hold, manage, possess, or otherwise handle investor funds or securities; or engage in other activities that the SEC determines.
While separate from the crowdfunding provisions, the JOBS Act also clarified that certain intermediaries in the fundraising process, such as web sites like AngelList that facilitate introductions between companies and investors, are not subject to broker-dealer registration. Section 201(c) of the JOBS Act provides that certain trading platforms involved with the sale of securities in a valid Rule 506 private placement are not subject to registration as a broker or dealer as long as certain conditions are met, including that persons receive no compensation in connection with the purchase or sale of securities and that the platform does not have possession of customer funds or securities in connection with the purchase or sale of securities.
Requirements for Issuers
Issuers utilizing crowdfunding must make financial and other information available to both the SEC and investors, both in connection with the offering and on an annual basis. The JOBS Act provides for a tiered disclosure regime based on the size of the offering, including the following:
• $100,000 or less: Income tax returns for the last fiscal year and unaudited financial statements certified as accurate by the principal executive officer.
• $100,000 to $500,000: Financial statements reviewed by an independent public accountant.
• More than $500,000: Audited financial statements.
As a practical matter, many early-stage startup companies that are considering crowdfunding may have only been recently incorporated and have not yet filed tax returns. Furthermore, many startup companies may not yet have engaged independent public accountants, nor have audited financial statements at the time they wish to raise funds.
Among other things, the issuer must file with the SEC and provide to investors and the intermediary and make available to potential investors:
• basic corporate information including name, legal status, address, and website;
• names of officers and directors (and any persons occupying similar status or performing similar functions);
• names of any holder of more than 20 percent of the shares of the issuer;
• description of the business and the anticipated business plan of the issuer;
• description of the stated purpose and intended use of the proceeds of the offering;
• target offering amount, deadline to reach such target amount, and regular updates relating to the issuer’s progress in meeting the target offering amount;
• the price to the public of the securities or the method for determining the price, and written disclosure prior to the sale of the final price and all required disclosures, providing investors with a reasonable opportunity to rescind the commitment to purchase;
• description of the ownership and capital structure of the issuer; and
• such other information as the SEC may prescribe.
Issuers must file annual reports with SEC and provide to investors reports of results of operations and financial statements as the SEC determines. However, many private companies wish to protect such sensitive financial information and may be disinclined from utilizing the exemption for this reason.
Furthermore, issuers may not advertise the terms of the offering except through notices that direct investors to the broker or funding portal. Compensation of intermediaries will be subject to rules designed to ensure that recipients disclose receipt of compensation.
In addition, the JOBS Act specifically authorizes an investor in a crowdfunding transaction to bring a civil action against an issuer for material misstatements or omissions in disclosures provided to investors. Such an action is subject to the provisions of Section 12(b) and Section 13 of the Securities Act.
The crowdfunding exemption will not be available to foreign companies, SEC reporting companies, investment companies, and companies excluded from the definition of investment company by virtue of Section 3(b) or 3(c) of the Investment Company Act of 1940.
The SEC is directed to promulgate disqualification provisions under which an issuer is not eligible to offer securities pursuant to new Section 4(6) of the Securities Act and brokers or funding portals shall not be eligible to effect or participate in crowdfunding transactions.
Coordination with State Law and Other Exemptions
Securities acquired pursuant to the crowdfunding provisions will be exempt from registration or qualification under state blue sky laws. In addition, states may not require a filing or a fee for crowdfunding securities except for the state of the principal place of business of the issuer or the state in which purchasers of 50 percent or greater of the aggregate amount raised are residents. However, the crowdfunding provisions preserve state enforcement authority over unlawful conduct by intermediaries and issuers and with respect to fraud or deceit.
While the JOBS Act specifically states that the crowdfunding amendments to the Securities Act are not to be interpreted as preventing an issuer from raising capital through other methods, it is unclear in practice how this will work. Private placements conducted through Regulation D-the most common type of private offering transaction-may be integrated with other offerings conducted within six months. Absent SEC clarification, significant questions regarding integration may inhibit a crowdfunding transaction at the same time as an angel or venture capital-led transaction with accredited investors is being conducted.
In addition, the SEC is directed to issue a rule to exclude persons holding crowdfunding securities from the shareholder threshold for registration under Section 12(g) of the Securities Exchange Act of 1934.
The crowdfunding provisions of the JOBS Act require significant SEC rulemaking, which is supposed to occur by December 31, 2012. In addition to specific areas that the SEC is supposed to address through rulemaking, the SEC is given wide discretion to prescribe various requirements on intermediaries and issuers for the protection of investors and in the public interest. The SEC has begun accepting public comments on regulatory initiatives under the JOBS Act, including the crowdfunding provisions.
SEC Chairman Mary Schapiro has publicly stated that the proposed rulemaking deadlines in the JOBS Act do not provide sufficient time for the SEC to consider and adopt rules under the act. Given these statements, it is not clear when companies actually will be able to take advantage of all of the provisions of the JOBS Act, including the crowdfunding provisions. Given the extensive SEC rulemaking required by the JOBS Act, and the investor protection issues involved, it is unclear whether the SEC will meet the deadline.
Raising Capital Apart from Crowdfunding
Other provisions of the JOBS Act provide opportunities to enable capital raising other than through crowdfunding. For example, Section 201(a)(1) of the JOBS Act directs the SEC to amend Rule 506 to make the prohibition against general solicitation or general advertising contained in Rule 502(c) inapplicable to offers and sales under Rule 506 provided that all purchasers are accredited investors. Section 201(b) amends Section 4 of the Securities Act to provide that offers and sales exempt under Rule 506 as revised by Section 201 “shall not be deemed public offerings under the Federal securities laws” as a result of general advertising or general solicitation. Section 201(a) requires the SEC to amend both Rule 506 and Rule 144A not later than 90 days after enactment of the JOBS Act. Therefore, after SEC rulemaking is complete, it may be easier for issuers to advertise Rule 506 offerings and raise capital through the sale of securities to accredited investors.
What the Crowdfunding Provisions Mean
First, companies should not try to utilize crowdfunding until the SEC finalizes rulemaking. Doing so would violate the securities laws and, in view of the “bad actor” provisions in the JOBS Act, may preclude a company from subsequently utilizing crowdfunding to raise capital.
Second, crowdfunding will clearly expand the options available to small companies seeking financing. As some early-stage startup companies have used Kickstarter to fund pre-sales of products, some startups may choose to use crowdfunding as an alternative to more conventional sources of funding.
Third, companies seeking to raise capital through crowdfunding will need attorneys involved to ensure that their corporate housekeeping is in order. Companies will need to ensure that an appropriate number and type of shares is authorized and review provisions relating to voting rights, board composition, and other matters that may be affected when the number of stockholders increases. In addition, companies will need to consider whether they will want their stockholders to enter into agreements imposing restrictions on share transfers, such as a company right of first refusal or IPO-related lock-up provisions. Furthermore, with a large number of stockholders, companies may want to review their director and officer indemnification provisions, and consider obtaining director’s and officer’s liability insurance.
Fourth, companies will be required to make filings with the SEC. Although these filings will be less burdensome than the filings required by public companies, they may still impose burdens on the resources of small companies, and may subject the companies and their officers and directors to potential liability if not properly prepared.
Fifth, many companies may be unable to prepare disclosure documents in compliance with the crowdfunding provisions of the JOBS Act. The SEC may use its rulemaking authority to prescribe a format, such as the Form 1-A Regulation A offering statement and the model offering circular contained in the form, which may impose a significant burden to raising a small amount of money.
Sixth, the increase in number of stockholders as a result of crowdfunding may result in increased administrative burdens on issuers. Stockholders may call or e-mail company personnel with questions or request meetings and may seek to avail themselves of rights to attend and participate in stockholder meetings and to inspect corporate books and records. Should litigation arise, it may be more challenging to manage such actions as the number of stockholders increases. In addition, if an issuer is the target of an acquisition, having a large number of stockholders may complicate securities law compliance.
Seventh, companies will need to choose intermediaries carefully. While some intermediaries’ websites have already begun to prepare for crowdfunding, the transaction fees charged by intermediaries have not yet been determined and there is the risk that fees will be excessive or that unscrupulous persons will masquerade as registered intermediaries.
Finally, it is possible that the attention given to crowdfunding may result in more elaborate schemes to defraud the public. Although the SEC will likely establish strict regulations on issuers and intermediaries, the perception that crowdfunding is legitimate may encourage unscrupulous persons to spam the public with various fraudulent crowdfunding opportunities not in compliance with the crowdfunding provisions of the JOBS Act. This may range from fraudsters operating fraudulent intermediaries to directly soliciting investments in fraudulent businesses.