Bar News - December 16, 2015
Business Law & Business Litigation: SEC Adopts Long-Awaited Crowdfunding Rules
By: Joel T. Shaw and Helen Sterling Coburn
Facilitating investment in small business was a critical component of the Jumpstart Our Business Startups Act of 2012. Among the various aspects of the law, a new federal exemption for “crowdfunding” generated the most excitement in the entrepreneurial community and the most controversy among securities regulators.
Rules recently finalized by the Securities and Exchange Commission (SEC), formally legalizing crowdfunding under the new exemption, will take effect May 16, 2016. The new “Regulation Crowdfunding” rules are an attempt to strike a delicate balance between the spirit of the legislation and investor protection considerations.
The type of crowdfunding that is regulated by Regulation Crowdfunding should be distinguished from other types of crowdfunding, such as Kickstarter, Indiegogo, or GoFundME. With the former, companies raise capital by selling securities to the public (implicating securities laws); with the latter, by contrast, companies raise funds by soliciting cash contributions in exchange for a product, gift, or even a written acknowledgment of the contribution.
Under applicable federal and state laws, every offer and sale of securities must be either registered or qualify for an applicable exemption from registration. Selling securities through crowdfunding is appealing, because companies are enabled to broadly distribute offering materials and to seek a limited amount of capital from the public – without having to go through the rigorous process of conducting an initial public offering or limiting sales to “accredited investors.”
Regulation Crowdfunding – The Basics
Regulation Crowdfunding (Section 4(a)(6) of the Securities Act of 1933, as amended) provides both a new federal exemption and limited state law preemption for crowdfunded securities offerings.
Companies. Section 4(a)(6) permits a company to raise a maximum of $1 million through crowdfunded offerings in a 12-month period. Capital raised during the same timeframe through other means is not counted in determining the aggregate amount sold. Regulation Crowdfunding does not limit the type of securities that may be offered – i.e., debt, equity, and hybrid securities may be sold. Companies subject to “bad actor” disqualification under existing SEC rules are prohibited from relying upon Section 4(a)(6).
Investors. Individual investments in all crowdfunded offerings by an investor in a 12-month period are limited to: (a) the greater of $2,000 or 5 percent of annual income or net worth, if the investor’s annual income or net worth is less than $100,000; or (b) 10 percent of annual income or net worth (not to exceed $100,000), if the investor’s annual income or net worth is $100,000 or more. There are no limitations on the type of investor who can participate in a crowdfunded offering.
Intermediaries. Crowdfunding transactions must be conducted exclusively through an “intermediary” registered with the SEC and the Financial Industry Regulatory Authority as either a broker-dealer or a “funding portal.” Intermediaries will use an online platform to connect companies with prospective investors (on an unsolicited basis), make available disclosure documents, provide communication channels, and otherwise coordinate transactions. Intermediaries also will be responsible for qualifying investors and taking certain steps to monitor for signs of offering fraud.
Advertising. Despite the public nature of crowdfunding, advertising is prohibited in an offering in reliance upon the Section 4(a)(6). Instead, Regulation Crowdfunding allows companies to publish a notice reflecting the terms of a proposed offering, which is similar to a so-called “tombstone ad” under existing SEC rules.
Transfer. For a period of one year after purchase, all transfers of securities purchased in a crowdfunded offering under Section 4(a)(6) are restricted, except: redemptions by the company; transfers to an accredited investor; sales as part of an SEC registered offering; and transfers to a member of the purchaser’s family (or to a trust for the benefit of a family member) or in connection with death, divorce, or a similar circumstance.
Disclosure and Reporting
A company undertaking a crowdfunded offering under Section 4(a)(6) is required to file a disclosure document with the SEC, which includes, among other things, information concerning the company’s business plan, management, intended use of proceeds, capital structure, and risk factors. Companies are also subject to varying GAAP compliant financial disclosure requirements, depending on the amount offered and sold pursuant to Section 4(a)(6) during the preceding 12 months. Finally, the company must also provide a narrative analysis of its financial condition, including, to the extent material, a discussion of liquidity, capital resources, and historical results of operations.
An annual report (containing information required in Regulation Crowdfunding) must be filed with the SEC and posted on the company’s website within 120 days after fiscal year end.
With Regulation Crowdfunding finalized, crowdfunding pursuant to Section 4(a)(6) will soon take its place among Regulation D, Rule 506(c), Regulation A+, and various state crowdfunding laws. The question of its ultimate utility for early-stage companies is still open, given the relatively small cap on investment and the risk of companies “crowding” their cap tables with a large number of small investors. Nevertheless, it is a thoughtful attempt to facilitate the capital raising process while balancing investor protection concerns.
|Helen Sterling Coburn
|Joel T. Shaw
Joel T. Shaw and Helen Sterling Coburn are experienced business and securities counsel and members of Bernstein Shur’s Private Capital Team. They advise operating companies, private funds, family offices, and individuals seeking to raise and invest capital.