On Oct. 30, 2015, the United States Securities and Exchange Commission (the “SEC”) released the long-awaited final rules for crowdfunding transactions, as required by Title III of the JOBS Act, the CROWDFUND Act. The new rules, which do not meaningfully alter the framework provided in the 2012 Act:
- Permit most issuers to offer and sell up to $1 million of securities per year to non-accredited investors in Internet crowdfunding transactions without registration under the Securities Act of 1933.
- Require issuers to make these offerings using Internet funding platforms maintained by FINRA-regulated crowdfunding intermediaries.
- Permit investors to purchase between $2,000 and $100,000 of securities in crowdfunding transactions each year, depending on their income and net worth.
- Require issuers to file with the SEC robust disclosure about their business, finance and ownership structure at the time of the offering and on an annual basis thereafter.
While there is excitement in some circles that the new rules will spark a surge in fundraising activity for early-stage companies, the burdens and expenses the rules impose on issuers may make crowdfunding a less attractive option to many issuers than alternative, established fundraising options.
Regulation Crowdfunding will become effective on Jan. 29, 2016. The basic requirements of Regulation Crowdfunding are set forth below.
Issuer Volume Limitation
An issuer and its affiliates may not sell more than $1 million in securities through crowdfunding transactions during any 12-month period.
Investor Volume Limitation
The total amount of securities any individual investor may purchase in all crowdfunding transactions from all issuers in any 12-month period is limited. The limitation is based on the investor’s annual income or net worth:
- The greater of $2,000 or 5% of the lesser of annual income or net worth, if either the annual income or net worth of the investor is less than $100,000.
- 10% of the lesser of annual income or net worth, if the annual income and net worth of the investor are greater than $100,000.
No investor may invest more than $100,000 in aggregate through crowdfunding offerings in any 12-month period.
Although most companies are now eligible to crowdfund under these regulations, certain issuers may not offer or sell securities using Regulation Crowdfunding. The CROWDFUND Act itself categorically excludes:
- Foreign issuers.
- Issuers that are reporting companies under the Securities Exchange Act of 1934.
- Issuers that are investment companies under the Investment Company Act of 1940, and issuers that rely on certain exemptions from the Investment Company Act.
In addition, Regulation Crowdfunding excludes:
- Issuers that are, or that have affiliates or insiders that are, “bad actors” as a result of certain statutory disqualifications.
- Issuers that have failed to satisfy the ongoing reporting requirements of Regulation Crowdfunding.
- Issuers that are blank-check companies (meaning they have no specific business plan or have indicated that such plan consists of engaging in a merger or acquisition with an unidentified company) and similar issuers.
Transaction Disclosure Requirements
While issuers in crowdfunding transactions are not required to prepare a full registration statement as they would have to do in an SEC-registered offering, they are required to provide substantial disclosure to potential investors using the newly created Form C.
Information that must be disclosed in Form C includes:
- The issuer’s directors, officers and each person holding more than 20% of its voting shares, calculated on the basis of voting power.
- A description of the issuer’s business.
- Financial information, depending on the size of the offering:
- Offerings under $100,000 – certain information from the issuer’s federal income tax return, certified by the issuer’s principal executive officer, and financial statements, certified by the issuer’s principal executive officer.
- Offerings over $100,000 but under $500,000 – financial statements reviewed by an independent public accountant.
- Offerings over $500,000 – audited financial statements, with first-time issuers permitted to provide financial statements that have been reviewed by an independent public accountant but not audited.
- Use of proceeds.
- Target offering amount and deadline, and whether the issuer will accept investments in excess of the target offering amount.
- Information about the offered securities and the issuer’s other securities, including substantial disclosure about the rights of crowdfunding investors relative to the issuer’s other investors.
- Certain information relating to the selected intermediary.
- Material risk factors of the issuer.
- Material terms of any indebtedness.
- Any exempt offerings conducted by the issuer in the past three years.
- Certain related-party transactions.
Significantly, these disclosures must be filed with the SEC a minimum of 21 days before the issuer’s first sale of securities in the crowdfunding transaction.
Issuers are also required to amend the offering documents during the offering period to reflect material changes and provide updates on the issuer’s progress toward reaching the target offering amount. Issuers are required to file reports with the SEC on new form C-U within five days of reaching certain milestones in the offering. These milestones include:
- When it receives commitments to purchase 50% of the offered securities.
- When it receives commitments to purchase all the offered securities.
- If it decides to accept subscriptions in excess of the original offering amount.
- When the offering closes.
However, the SEC has provided some flexibility on this requirement by allowing that if an issuer makes publicly available on an intermediary platform frequent updates regarding the issuer’s progress in raising funds (as is common in on-line fundraising platforms), the issuer need not file intermediary C-U forms. It need only file a final Form C-U disclosing the total amount of securities sold in the offering after the offering closes.
Restrictions on Advertising
Regulation Crowdfunding strictly limits issuers’ ability to communicate with potential investors about the offering or to advertise the offering outside the platform. Issuers are only permitted to use a “tombstone”-type advertisement that contains only the following:
- The fact that the issuer is conducting an offering.
- The intermediary and a link to the its website for the offering.
- The amount of securities offered.
- The type of securities offered.
- The price of the securities offered.
- The closing date.
- The contact information of the issuer and its representative.
- A short factual description of the issuer’s business.
However, issuers may use the intermediary’s platform to communicate with investors about the offering, as long as the issuer identifies itself in all communications.
Restrictions on Transfer
Securities sold in offerings under Regulation Crowdfunding must generally be held by the purchaser for one year. The only exceptions are transfers:
- Back to the issuer.
- To family members, to a trust controlled by the purchaser or for the benefit of a family member, or in connection with the death or divorce of the purchaser.
- To accredited investors.
- In an SEC-registered transaction.
Ongoing Reporting Requirements
An issuer that completes an offering under Regulation Crowdfunding will be required to file with the SEC and make available on its website annual reports on new Form C-AR. These reports must include substantially the same qualitative disclosure required in the Form C used for the offering, as well as annual financial statements certified by the issuer’s principal executive officer.
An issuer must comply with the ongoing reporting requirements indefinitely until one of the following occurs:
- The issuer becomes a reporting company under the Exchange Act.
- The issuer has filed at least one Form C-AR and has fewer than 300 holders of record of its securities.
- The issuer has filed Forms C-AR for at least the three most recent years and has total assets of less than $10 million.
- The issuer or a third-party acquires, redeems or repays all the securities.
- The issuer dissolves or liquidates.
Issuers must affirmatively terminate their reporting requirements by filing a Form C-TR with the SEC after one of these events occurs.
Crowdfunding transactions must be conducted through a broker or “funding portal” that has registered with the SEC and FINRA. These intermediaries will play an important gatekeeping role in crowdfunding transactions, and they will have significant responsibility for preventing issuer fraud and for protecting investors. Intermediary duties include educating and screening potential investors, taking appropriate action to reduce the risk of fraudulent transactions (including checking the background of the issuer and its insiders), providing disclosure to the SEC, ensuring that the issuer does not receive any investors' money until the target offering amount has been raised and taking steps to ensure that investors do not purchase more than their annual limit of crowdfunding securities.
The intermediaries are also subject to substantial restrictions on their and their employees’ conduct and compensation. Among other things, directors, officers or partners of intermediaries may not have any financial interest in an issuer. Intermediaries also may not have any “financial interest” in an issuer, except that they may receive securities of the same class and terms as those offered by the issuer as compensation for the services provided to the issuer in connection with the same offering.
In general, issuers in most private placements are subject to private liability Rule 10b-5 of the Securities Exchange Act of 1934. It is comparatively hard for an aggrieved purchaser to establish liability under Rule 10b-5 because the purchaser must prove that the issuer acted with “scienter,” a term of art that is roughly equivalent to recklessness in most courts’ view. Conversely, issuers in crowdfunding transactions will also be subject to the “strict liability” provisions of Sections 12(b) and 13 of the Securities Act. These provisions give purchasers a right of rescission if the issuer’s disclosure in connection with a crowdfunding transaction includes material misstatements or omissions and the issuer knew or should have known about the misstatement or omission. Accordingly, it will generally be easier for aggrieved purchasers to successfully bring securities actions against issuers in crowdfunding transactions than in most other types of private placement.
While the Crowdfunding Exemption will give certain issuers access to investors that they would not be able to reach through traditional private placements, the risks, burdens and expenses that come with the Crowdfunding Exemption will likely make it less attractive to most issuers than the alternative private placement structures available to them. Despite these issues, Regulation Crowdfunding offers issuers another option for raising money. It may have particular appeal to issuers who have exhausted the resources of “friends and family” investors but do not have access to accredited investors and other investors that invest in traditional private placements. It is also significant in finally completing the 2012 JOBS Act implementation and helping the SEC keep up with the reality of the diverse fundraising platforms being used today.