Analysis of Crowdfunding Rules Relating to Issuers
On October 23, 2013 the Securities and Exchange Commission (the “SEC”) issued proposed regulations (the “Proposed Rules”) with respect to crowdfunding as contemplated by Title III of the Jumpstart our Business Startups Act of 2012 (the “JOBS Act”). The Proposed Rules are open for comment for 90 days from the date of publication in the federal register (a period that will likely run to the end of January, 2014).
While the Proposed Rules will not be effective until adopted by the SEC, and the SEC may change the Proposed Rules before adopting them, if adopted in their present state the Proposed Rules will make it possible for privately-owned company to sell securities to investors over the Internet through registered “crowdfund portals.” Under the Securities Act of 1933 (the “1933 Act”), companies may not sell securities to investors unless the securities are either registered (generally requiring an initial public offer or “IPO”) or exempt from registration. The crowdfunding authorized by Congress through the JOBS Act creates a new exemption from registration (now contained at Section 4(a)(6) of the 1933 Act) and the Proposed Rules, if adopted, would make it possible for sales of securities under this new exemption to commence.
This post will summarize the provisions of the Proposed Rules applicable to issuers of securities under the new Section 4(a)(6) exemption. A second Law Alert, to be published shortly, will cover the provisions of the Proposed Rules applicable to crowdfund portals.
How the Proposed Rules Affect Issuers
Disclosure and Financial Statement Requirements
Section 4A(b)(1) of the 1933 Act requires issuers relying on the Section 4(a)(6) exemption to conduct a crowdfunding offering to file certain information with the SEC, and to provide it to investors, potential investors and the crowdfunding intermediary for the offering.
Section 4A(b)(1)(I) of the Securities Act gives the SEC authority to require additional disclosure.
Under the Proposed Rules, a crowdfunding issuer must prepare and file a Form C on EDGAR before the commencement of the offering. Among other things, Form C would need to include information on:
- The issuer itself, including name, address and entity form.
- The issuer's directors and officers, including their history with the company, business experience for the past three years and other information.
- The issuer's 20% or greater beneficial equityholders.
- The issuer's business and business plan. The proposal does not prescribe the details of this requirement, but the Proposed Rules ask for comment on whether it should do so, including by providing a non-exclusive list of required information or requiring line-item responses.
- The use of proceeds.
- The target offering amount and deadline to reach it. Issuers would also be required to describe how investors may cancel an investment commitment and include statements that:
- commitments may be cancelled until 48 hours before the deadline;
- if a material change to the offering occurs, investors must reconfirm their commitment or it will be cancelled and funds returned; and
- if the target offering amount is not met, commitments will be cancelled and funds returned.
- The offering price and how it will be determined.
- The issuer's ownership and capital structure, including information about the terms (such as voting rights and transfer restrictions) of the securities being offered and other outstanding securities. Other information, including about the risks of being a minority owner, would be required.
- The following matters (these disclosure requirements are not directly required by statute):
- the intermediary for the offering and compensation being paid to the intermediary;
- number of current employees of the issuer;
- risk factors;
- material terms of the issuer's indebtedness;
- exempt offerings of the issuer in the last three years; and
- certain related party transactions.
The Proposed Rules would require an issuer to provide the following financial information, depending on the aggregate amount the issuer offers and sells under Section 4(a)(6) in a rolling 12-month period:
- Offerings of $100,000 or less. US GAAP financial statements for the two most recently completed fiscal years or shorter period during which the issuer has been operating, and filed income tax return for the most recently completed fiscal year, if any, in both cases certified true and complete by the issuer's principal financial officer. Grace periods are provided, and certain personal information may be redacted.
- Offerings of between $100,000 and $500,000. US GAAP financial statements reviewed (in accordance with AICPA standards) by a public accountant independent of the issuer under Rule 2-01 of Regulation S-X and accompanied by the accountant's review report.
- Offerings over $500,000. US GAAP financial statements audited (in accordance with AICPA or PCAOB standards) by an independent auditor, accompanied by the audit report.
An issuer would also be required to provide a narrative discussion of its financial condition covering, among other things, its historic results of operations and liquidity and capital resources. According to the proposing release, this discussion would be similar to the “management’s discussion and analysis” (or “MD&A”) required in the financial statements mandated for publicly-traded companies, but generally not as lengthy or detailed considering the probable more limited operating history, complexity and scale of crowdfunding issuers.
A crowdfunding issuer would need to file updates to Form C (designated Form C-U) with information on the company's progress toward reaching its target offering amount. An issuer would need to amend its disclosure if a material change or update occurred (on a filing designated Form C-A).
Each Section 4(a)(6) issuer would be required to file with the SEC and post to its website an annual report within 120 days of the end of each fiscal year (on a filing designated Form C-AR). This annual report would include information similar to the offering statement on Form C, including the financial statement and narrative disclosures meeting the highest standard applicable to any of the issuer's past Section 4(a)(6) offerings, but excluding offering-specific information.
The annual reporting requirement would continue until one of the following events occurred:
- The issuer becomes a reporting company.
- All the issuer's securities sold under Section 4(a)(6) are purchased by a third party or repurchased by the issuer.
- The issuer liquidates or dissolves its business under state law.
The issuer would be required to file a notice of termination of its annual reporting obligation on Form C-TR.
Advertising and Communications
Under the Proposed Rules, issuers would only be permitted to advertise their offerings through a notice containing certain specific limited information (similar to "tombstone ads" under Rule 134 under the 1933 Act). The notice must direct readers to the crowdfunding intermediary platform for the offering. Potential investors could then access additional information about the offering through the platform. The notice could be in print or distributed electronically, including through social media.
However, under the Proposed Rules, there would be no restriction on an issuer's ability to:
- Communicate with investors or potential investors on the intermediary's platform, as long as the issuer identifies itself as the issuer in these communications. This allows the issuer to answer questions or challenge statements made about it during the offering process.
- Make communications that do not refer to the terms of the offering (for example, the issuer could continue to advertise its products or services).
Limits on Capital Raised and Individual Investment
The Section 4(a)(6) exemption is limited by its terms to offerings not exceeding maximum amounts of capital raised and amounts invested. The Proposed Rules is designed to help issuers and investors apply these statutory limits. The Proposed Rules clarify:
- Application of the $1 million per issuer, per year capital raise maximum. Under the proposal, only securities sold under Section 4(a)(6) (and not any other exemption from registration) would count toward an issuer's $1 million capital raise maximum. In calculating the limit, an issuer would be required to add together proceeds raised in Section 4(a)(6) issuances by the issuer itself, its predecessors and entities it controls or is under common control with. The amount of these issuances cannot exceed $1 million in any rolling 12-month period.
- Investment limits. There is an important ambiguity in the language of the JOBS Act itself, limiting the amount an issuer may sell in any one year to any single investor in crowdfunding offerings. The Proposed Rules try to resolve the ambiguity by permitting crowdfunding issuers to rely on the efforts of crowdfunding intermediaries to determine whether an investor has reached the limits (provided that the issuer does not have actual knowledge to the contrary).
In the issuing release, the SEC stated that Section 4(a)(6) offerings would not be integrated with any other exempt offerings by the issuer, as long as each offering complies with its respective exemption. However, if an issuer is conducting a Section 4(a)(6) offering at the same time as an offering made in reliance on an exemption that does not permit general solicitation (such as a private offering under Rule 506(b)), the issuer would need to be satisfied that investors in the latter offering became interested in the offering through means other than general solicitation regarding the Section 4(a)(6) offering.
This requirement could become problematic as it would require the issue to demonstrate how a non-crowdfunded investor came to know about the exempt offering. It is difficult to imagine how an issuer could satisfy this requirement, other than through a self-serving certification made by the investor.
The Proposed Rules include two requirements intended to ensure crowdfunding offerings permit public access to information about the offering and information sharing among the "crowd." The proposal would require that each offering be conducted using only one intermediary and all offerings be conducted on the internet.
Ineligible Companies and Bad Actor-style Disqualification
Section 4A(f) of the 1933 Act (as amended by the JOBS Act) makes certain categories of issuers ineligible to rely on Section 4(a)(6) (including foreign issuers, reporting companies, investment companies and companies excluded from that definition by Sections 3(b) and (c) of the Investment Company Act (including most hedge funds). The Proposed Rules would also make the following issuers ineligible to rely on Section 4(a)(6):
- Issuers that failed to make required Form C filings in the two years before a crowdfunding offering.
- Issuers with no business plan or a business plan to engage in a merger with an unidentified company or companies.
Section 302(d) of the JOBS Act requires the SEC to establish a disqualification provision for crowdfunding offerings substantially similar to those of Rule 262 of Regulation A. The Proposed Rule would adopt disqualification provisions similar to Rule 506(d), which disqualifies certain issuers from relying on the Regulation D safe harbor from Securities Act registration. [Analysis of Rule 506(d) rules]
Under the Proposed Rules, an issuer will be unable to rely on the crowdfunding exemption if any person covered by the rule was involved in a "disqualifying event." Covered persons include:
- The issuer, its predecessors and certain affiliates.
- Any of the issuer's directors, officers, general partners or managing members.
- Any 20% beneficial owner of the issuer (calculated by voting power).
- Any promoter connected with the issuer at the time of sale.
- Any compensated solicitor for the offering.
- Any director, officer, general partner or managing member of a compensated solicitor for the offering.
The disqualifying events covered by the Proposed Rules are modeled on those of Rule 262, and include, among other things, certain securities-law related injunctions and restraining orders entered in the last five years and certain regulatory orders entered in the last ten years. Like the Rule 506 disqualification provision, the Proposed Rules would include an exception for disqualifying events that the issuer did not know of and, in the exercise of reasonable care, could not have known of.
Under the Proposed Rules, if an issuer compensates a person to promote the offering through the crowdfunding intermediary's communication channels, the issuer must take reasonable steps to ensure the compensated promoter identifies itself as such.
As required by Section 4A(e) of the 1933 Act (as amended by the JOBS Act), securities purchased in a crowdfunding transaction cannot be resold for a period of one year, unless they are sold to the issuer, to an accredited investor, as part of a registered offering or to a family member of the purchaser in connection with certain events like death or divorce.
Safe Harbor for Insignificant Deviations
The Proposed Rules include a safe harbor for issuers that attempt to comply with Section 4(a)(6) but fail to do so. The safe harbor is modeled in part on a similar provision in Rule 508 of Regulation D.
The Proposed Rules also include provisions relating to oversubscription, the setting of the offering price, the types of securities that may be offered and valuation.
Crowdfunding Securities Exempt from Section 12(g) Cap
Section 12(g) of the Securities Exchange Act of 1934 (the “1934 Act”) requires an issuer to register a class of equity securities (making the company a reporting company) when its assets and the number of record shareholders of that class of securities exceed certain thresholds. The JOBS Act added Section 12(g)(6) to the Exchange Act, requiring SEC rulemaking to exclude from Section 12(g)'s record holder calculation securities acquired in crowdfunding offerings.
Proposed Rule 12g-6 would permanently exempt from the record holder count securities issued in a Section 4(a)(6) offering. A crowdfunding issuer seeking to exclude a person from its record holder count would have the burden of demonstrating that person's securities were initially issued in a crowdfunding offering.