Proposed Crowdfunding Rules – Part I

As required by Title III of the JOBS Act, on October 23, 2013, the SEC has published proposed crowdfunding rules.  The SEC has dubbed the new rules “Regulation Crowdfunding.” The entire text of the rule release is available on the SEC website.

Background

Crowdfunding generally is where an entity or individual raises funds by seeking small contributions from a large number of people.  The crowdfunder sets a goal amount to be raised from the crowd with the funds to be used for a specific business purpose.  In addition, a crowdfunding campaign allows the crowd to communicate with each other, thus adding the benefit of the “wisdom of the crowd.”  Small businesses can particularly benefit from crowdfunding as they are not limited by restrictions on general solicitation and advertising or purchaser qualification requirements.

Title III of the JOBS Act, called the Crowdfund Act, amends Section 4 of the Securities Act of 1933 (the Securities Act), adding new Section 4(a)(6) to create a new exemption to the registration requirements of Section 5 of the Securities Act.  The new exemption allows Issuers to solicit “crowds” to sell up to $1 million in securities in any 12-month period as long as no individual investment exceeds certain threshold amounts.

The threshold amount sold to any single investor cannot exceed (a) the greater of $2,000 or 5% of the annual income or net worth of such investor if the investor’s annual income or net worth is less than $100,000; and (b) 10% of the annual income or net worth of such investor, not to exceed a maximum of $100,000, if the investor’s annual income or net worth is more than $100,000.  When determining requirements based on net worth, an individual’s primary residence must be excluded from the calculation.  Clearly there is a conflict in the language determining threshold amounts; an investor could fall within both categories.  The conflict has been pointed out in numerous letters to the SEC and will presumably be addressed in the rule making.

Section 302 of the Crowdfund Act requires that all crowdfunding offerings be conducted through an intermediary that is a broker-dealer or funding portal that is registered with the SEC and a member of a registered self-regulatory organization (SRO).  Currently that SRO is the Financial Industry Regulatory Authority (FINRA).  Although funding portals will have to register with the SEC and become a member of FINRA, they will not have to register as a broker-dealer.  FINRA has already published proposed rules to regulate funding portals.

In addition, the Crowdfund Act requires that Issuers and intermediaries provide certain information to investors, potential investors and the SEC. The ability to utilize crowdfunding will be subject to bad boy restrictions and other disqualifying events.  All crowdfunding Issuers must be United States entities.  Crowdfunding Issuers cannot be subject to the reporting requirements of the Securities Exchange Act of 1934 or an investment company as defined by the Investment Company Act of 1940.

The JOBS Act required the SEC to draft rules implementing the provisions of the Act.  On October 23, 2013, the SEC issued a 585-page rule release.  This is the first in my summary of the proposed rules.

The SEC Rule Release – Introduction and Background

The SEC begins its rule release with a lengthy discussion of the crowdfunding concept and the difficulty in balancing rules that are not unduly burdensome, and thus discourage participation in crowdfunding on the one hand with rules that are too permissive and thus increase the risk for investors.  The SEC also recognizes that the SEC staff will need to monitor the practical implementation of the new rules closely and implement amendments and interpretations as necessary as a workable crowdfunding system is created in the U.S.

Summary Breakdown of Proposed New Rules – The Crowdfunding Exemption

                Limitation on Capital Raised

The exemption from registration provided by Section 4(a)(6) is available to a U.S. Issuer provided that “the aggregate amount sold to all investors by the issuer, including any amount sold in reliance on the exemption provided under new Section 4(a)(6) during the 12-month period preceding the date of such transaction, is not more than $1,000,000.”  This wording opened debate as to which other exempt offerings, if any, would be integrated with the $1,000,000 limit for the new Section 4(a)(6) exemption. The SEC concluded that “the overall intent of providing the exemption under Section 4(a)(6) was to provide an additional mechanism for capital raising for startup and small businesses and not to affect the amount an issuer could raise outside of that exemption.”

In the proposed rule, capital raised through other means does not aggregate or integrate with capital raised under the Section 4(a)(6) Regulation Crowdfunding exemption.  Moreover, capital raised through non-equity based crowdfunding (such as donation or reward offerings) would also not aggregate or integrate in determining the $1,000,000 limit.  An Issuer could complete an offering made in reliance on Section 4(a)(6) that occurs simultaneously with, or is preceded or followed by, another exempt offering.

However, Section 4(a)(6) offerings conducted by entities controlled by or under common control with the Issuer do aggregate and integrate with the Issuer’s offering.   Securities Act Rule 405 defines “control” as “possession, direct or indirect, of the power to direct or cause the direction of the management and policies of a person, whether through the ownership of voting securities, by contract, or otherwise.”  Offerings by predecessor Issuers also integrate and aggregate with the Issuer’s offerings.

In addition, caution would need to be taken if the simultaneous offering were being conducted under an exemption that did not allow advertising.

The SEC has sought comment as to whether the $1 million limit should be net of fees charged by funding platforms and/or broker-dealers; whether any other exempt offerings should integrate with a Section 4(a)(6) exempt offering; whether non-equity crowdfunding offerings should integrate with a Section 4(a)(6) offering; whether there be limitations on concurrent offerings; whether there should be limitations on concurrent advertised 506(c) offerings and/or cooling-off periods before or after such offerings and a 4(a)(6) offering; whether a new definition of “control” should be adopted or the SEC should rely on the current Rule 405 definition; and whether offerings by predecessor Issuers should integrate with the current Issuers’ offering.

Investment Limitation

As written in the JOBS Act, the aggregate amount sold to any single investor cannot exceed (a) the greater of $2,000 or 5% of the annual income or net worth of such investor if the investor’s annual income or net worth is less than $100,000; and (b) 10% of the annual income or net worth of such investor, not to exceed a maximum $100,000, if the investor’s annual income or net worth is more than $100,000.  Practitioners and commenters, including myself, quickly started pointing out that a conflict existed and that an investor could fall within the limits of both categories.  Moreover, the JOBS Act rule as written did not specify at what point in time the 5% or 10% is to be applied or to which number (net income or net worth).  Ambiguity is also apparent in determining the $2,000 floor vs. $100,000 ceiling.  Accordingly, the SEC had greater discretion in drafting this portion of the proposed rules than in other areas where no ambiguity existed related to the Congressional directives.

The proposed rules provide for an overall investment ceiling of $100,000 with “greater than” limitations based on annual income and net worth.  That is, if both annual income and net worth are less than $100,000, then a limit of $2,000 or 5% of annual income or net worth, whichever is greater, would apply.  If either annual income or net worth exceeds $100,000, then a limit of 10% of annual income or net worth, whichever is greater, not to exceed $100,000 would apply.

Annual income and net worth are both to be calculated the same as they are calculated in determined accredited investor status under Securities Act Rule 501.  The investment limitations apply to all investors including retail, institutional, accredited, and both U.S. and non-U.S. citizens and residents.

Issuers will be able to rely on the funding intermediaries (i.e., funding portal or broker-dealer) to determine whether investors comply with their investment limits, except where the Issuer has actual knowledge otherwise.

The SEC has sought comment as to, among other items, whether the rule should be based on a “lower of” instead of “greater than” calculation; whether an exception to the use of the accredited investor rule should be written for calculating joint income or net worth with spouses; whether it is appropriate to allow an Issuer to rely on an intermediary for determining investor compliance with limits; and whether institutional or accredited investors should be subject to the investor limitations at all.

Transaction Conducted Through an Intermediary 

Section 4(a)(6)(C) requires that all crowdfunding offerings be conducted through an intermediary that is a broker-dealer or funding portal that is registered with the SEC and a member of a registered self-regulatory organization (SRO).   The SEC believes that requiring an Issuer to use only one intermediary, rather than multiple intermediaries, to conduct a Regulation Crowdfunding offering helps foster the creation of a crowd and serves the statutory purpose.  In addition, from a practical perspective it would be difficult to determine compliance with the $1,000,000 limitation on capital raised and investor investment limitations if multiple intermediaries are allowed.  Accordingly, the proposed rules prohibit an Issuer from using more than one intermediary to conduct a 4(a)(6) offering.

In addition, the proposed rules require that funding platforms conduct Section 4(a)(6) offerings exclusively through their electronic platforms (i.e., no offline transactions).  The proposed rules define “platform” to mean an “internet website or other similar electronic medium through which a registered broker or a registered funding portal acts as an intermediary in a transaction involving the offer or sale of securities in reliance on Section 4(a)(6).”  To avoid doubt, the SEC specifies that back office and administrative procedures such as document maintenance and preparation of confirmations and notice may be completed offline. To facilitate this requirement, intermediaries will be required to have investors consent to the electronic delivery of all documents and information connected with the offering.

The SEC has sought comment as to, among other items, whether the proposed requirement limiting offerings to a single intermediary should be modified; whether offline transactions should be allowed; if so, whether they should be limited in nature or geographical scope; whether intermediaries should be allowed to restrict access to their platform by either investor qualification or category or Issuer qualification or category; and whether better definitions of back-office and administrative functions are required.

Exclusion of Certain Issuers From Eligibility Under Section 4(a)(6)

The JOBS Act requires that all crowdfunding Issuers must be United States entities.  Crowdfunding Issuers cannot be subject to the reporting requirements of the Securities Exchange Act of 1934 or an investment company as defined by the Investment Company Act of 1940. The ability to utilize crowdfunding is also subject to bad boy restrictions and other disqualifying events.

The proposed rules include the JOBS Act requirements that Issuers be United States registered entities, not be subject to the Securities Exchange Act reporting requirements and not be investment companies under the Investment Company Act.  In addition, the proposed rules contain the required bad boy disqualification provisions.

In addition, the proposed rules disqualify any Issuer that does not file required ongoing annual reports with the SEC, as required by Regulation Crowdfunding, during the two years immediately preceding the current offering.

The proposed rules disqualify blank check companies, i.e., 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.  However, the SEC specifically does not disqualify early-stage or start-up entities, noting that it is these entities that will benefit the most from Regulation Crowdfunding by obtaining “input from the crowd” on business plans and ideas at the inception.

The proposed rule also disqualifies hedge funds and private funds.

The SEC has sought comment as to, among other items, whether issuers should be disqualified for the failure to meet crowdfunding annual reporting requirements; whether a two-looks-back time frame is appropriate; whether an Issuer should be disqualified for being delinquent or otherwise not timely in its reports; whether the reporting disqualifications should extend to affiliate or predecessors; whether rules should be enacted to protect investors from “idea” or “business plan” start-up entities without real operations; and whether other categories of disqualifications should be added.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com

Securities attorney Laura Anthony and her experienced legal team provides ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded issuers as well as private companies going public on the NASDAQ, NYSE MKT or over-the-counter market, such as the OTCQB and OTCQX. For nearly two decades Legal & Compliance, LLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions as well as registration statements on Forms S-1, S-8 and S-4; compliance with the reporting requirements of the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; Regulation A/A+ offerings; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers, ; applications to and compliance with the corporate governance requirements of securities exchanges including NASDAQ and NYSE MKT; crowdfunding; corporate; and general contract and business transactions. Moreover, Ms. Anthony and her firm represents both target and acquiring companies in reverse mergers and forward mergers, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. Ms. Anthony’s legal team prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the OTC Market’s top source for industry news, and the producer and host of LawCast.com, the securities law network. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Las Vegas, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.

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