Showing 18 posts from October 2013.
Schweikert, one of the early proponents of the crowdfunding provisions in the 2012 JOBS Act, said:
“If we’re in a world where we have crushing debt screaming toward us and some of that is coming because of what we’re being told is the new normal of a 2% GDP growth outlook, we need to be doing things that accelerate economic growth or we’re in incredible trouble."
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.
In a unanimous vote the SEC today adopted proposed crowdfunding rules. Here is a link to the proposed rules.
Within a few hours of the SEC's release of its proposed crowdfunding rules, FINRA (the Financial Industry Regulatory Authority) issued its proposed rules for crowdfund portals.
Under the JOBS Act of 2012, crowdfunding will be permitted only through crowdfund portals that are registered with the SEC and duly licensed through a designated self regulatory organization ("SRO"). FINRA has been designated the SRO for crowdfund portals so today's dual announcements should provide clarity for how this new category of financial intermediary will take shape.
The proposed rules (entitled, "FINRA Regulatory Notice 13-34") are available for comment until February 3, 2014.
If all goes well, both the SEC and FINRA rules might be finalized and effective in the first half of 2014.
The SEC has formally announced that it will hold a public meeting on October 23 to determine whether to release proposed crowdfunding rules.
At Stu Lustman's P2P Lending Expert site I have posted an analysis of Prosper Lending's securities law compliance.
Cheryl Conner, writing in Forbes, advances an idea that I have been developing: that crowdfunding may become a form of marketing for some emerging growth ventures.
In addition to the capital raised, the CF campaign:
- validates the idea by recruiting a large group of followers;
- builds a nucleus of proponents or evangelists who will expound the new venture to their friends;
- creates awareness of the new venture in the broader marketplace; and
- forces the entrepreneur to focus on the new venture's value proposition in a very focused and immediate way.
Business writer Dave Michaels, writing in Bloomberg’s Businessweek has penned a piece under the headline, “SEC to Issue Crowdfunding Proposal Easing Investor Verification.”
The article explains that “Small businesses raising money by selling shares over the Internet wouldn’t have to verify that their backers comply with individual investment limits under a U.S. regulatory proposal set for a vote as soon as next week.”
The article is potentially confusing to those trying to follow the numerous changes now being rolled out that affect capital formation for emerging growth companies. My hope in writing this is to eliminate that potential confusion.
The 2012 JOBS Act, among its other efforts, was intended to make possible securities-based crowdfunding on a nationwide basis. Title III of the JOBS Act created a comprehensive system by which private companies could sell securities (equity or debt) to investors in the U.S. on licensed “crowd-fund portals”. Investors would be limited in the amount of money they could invest in a crowdfunded offering based upon their income levels.
Congress directed the SEC to adopt regulations implementing Title III within 270 days after the law’s enactment. More than 1.5 years have elapsed and the SEC still has not adopted those necessary regulations, although SEC Chair Mary Jo White has been quoted to say that she expects those regulations out by the end of 2013.
The Bloomberg article describes a “regulatory proposal” that would expressly relieve issuers of securities in crowdfunded offerings from having to verify the income levels of participating investors.
Importantly, no regulatory proposal has yet been released to the public, and Dave Michaels notes that he is relying on unnamed sources within the SEC “with direct knowledge of the matter who asked not to be named because the proposal hasn’t been made public.” Assuming that the rumor is true, however, it is also important to understand what this proposal would, and would not, cover.
Although crowdfunding under Title III of the JOBS Act prohibits investors from making investments greater than their income-related levels, that prohibition is only one of several requirements. Even if the rumored proposal were adopted, that would not allow companies to start issuing securities in crowdfunded offerings any time soon. The SEC would still need to adopt all of the other regulations required to implement crowdfunding, including a comprehensive description of the licensing requirements for the yet-to-be-defined “crowd-fund portals”. Because the licensing of the crowdfund portals is likely to fall within FINRA’s purview, even the completion of the SEC’s rules will not be enough to implement crowdfunding because FINRA would also be required to adopt procedures for portal licensing. Once adopted, potential portals would need to complete the FINRA licensing process before launching, a process that would likely take months.
So, while a proposed rule that relieved issuers from a duty to verify an investor’s income would be a step forward, it would not come anywhere close to completing the regulatory work needed to implement crowdfunding under the JOBS Act.
It’s also important for those following these issues to understand how investor income verification is a separate topic from accredited investor status as it relates to Regulation D.
Before the advent of crowdfunding, private offerings under Regulation D were the primary means of capital formation for emerging growth companies. Under the mandates of the JOBS Act the SEC has recently adopted regulations making it possible for private companies to issues securities under Regulation D through public solicitations under Rule 506(c). One of the requirements of these new “public/private” offerings is that all of the participating investors be accredited investors (a category that is defined by either the investor’s income or net worth). A key element of the new Regulation D rules is that securities issuers must take additional steps to verify the status of each investor as an accredited investor through a process that might require the issuer to verify the issuer’s income.
The proximity of Dave Michael's rumored income verification rule for crowdfunding with the accredited investor status verification rule under Regulation D could become confusing for some. Even if the rumored proposal eliminated a duty on the part of an issuer to verify income for compliance with Title III of the JOBS Act, that proposal would have no bearing on the issuer’s duty to verify accredited investor status (via income or net worth) for purposes of an exempt private offering under Regulation D.
The Wisconsin crowdfunding bill has passed the state Senate and now moves to the desk of Wisconsin Governor Scott Walker.
Quoting the Milwaukee Business Journal:
“Where the federal government has delayed, Wisconsin has acted,” said Rep. David Craig, (R-Vernon), one of the bill’s lead co-authors, in a prepared statement. “Where other states have failed to allow small business to harness the power of the Internet, Wisconsin has embraced it. Sen. (Leah) Vukmir, Rep. (Chad) Weininger and I have put our joint time and efforts into crafting this important legislation, and with the overwhelming support of the Legislature we look forward to Gov. Walker signing this important jobs bill in the near future.”
The Wisconsin bill, if passed into law, would make Wisconsin the third state to permit intrastate crowdfund offerings.
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