On Oct. 24, 2013, the United States Securities and Exchange Commission (the “SEC”) released proposed rules (the “Proposed Rules”) for crowdfunding transactions, as required by Title III of the JOBS Act, the CROWDFUND Act. Under the Proposed Rules, which do not meaningfully alter the framework provided in the CROWDFUND Act, certain issuers will be able to use internet portals to offer and sell up to $1 million of securities per year to ordinary investors without registration under the Securities Act of 1933 (the “Crowdfunding Exemption”).
Although the Crowdfunding Exemption has been eagerly awaited by many early-stage businesses, it will likely be an unattractive fundraising alternative for a number of reasons, including:
- The disclosure requirements for issuers, including financial statement and ongoing SEC reporting requirements, are burdensome, and compliance is expensive.
- Many issuers will find the retail investors who are likely to invest in crowdfunding transactions much more challenging to deal with than traditional private placement investors.
- Crowdfunding transactions will carry with them more risk of investor litigation than traditional private placements.
- The financial entities that have shown interest in serving as the intermediaries required in crowdfunding transactions generally have limited resources and little experience in retail securities transactions, which may mean that they will not be able provide issuers the support and guidance they need as they approach retail investors for the first time.
The Proposed Rules are open for public comment until shortly after Jan. 21, 2014, after which the SEC will publish final rules. The Crowdfunding Exemption will not be available until those final rules have been enacted. The Proposed Rules can be found here.
The Crowdfunding Exemption
Traditionally, crowdfunding has been viewed as a way to raise money by getting small investments from a large number of individual investors, without regard to the means or sophistication of the investors or their prior relationship with the business raising money. Over the last few years, early-stage businesses have been using internet crowdfunding platforms such as Kickstarter to raise money with some success, but the fundraising potential of these platforms has been limited because the federal securities laws prohibit businesses from using them to offer securities or other investments. Instead, businesses have been able to provide only modest consideration, essentially thank you gifts, such as t-shirts or early editions of their products, in return for their supporters’ funds. While new Rule 506(c) of Regulation D, which removes the prohibition on general solicitations and advertising for certain private placements, gives private issuers a way to use the internet to publicize their securities offerings, Rule 506(c) does not permit true “retail” crowdfunding because only accredited investors can purchase securities in Rule 506(c) transactions.
The Crowdfunding Exemption will provide a vehicle, albeit a limited one, for genuine retail crowdfunding. The requirements of the Crowdfunding Exemption include the following:
Issuer Volume Limitation
An issuer 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 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 annual income or net worth, if the annual income and net worth of the investor are each less than $100,000; or
- 10% of annual income or net worth, up to a maximum of $100,000, if the annual income or net worth of the investor is greater than $100,000.
Issuer 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. Information that must be disclosed includes:
- The issuer’s directors, officers and each person holding more than 20% of its voting shares, calculated on the basis of voting power.
- The issuer’s business plan.
- Financial information, depending on the size of the offering:
- Offerings under $100,000 – income tax returns 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.
- Use of proceeds and target offering amount and deadline.
- 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 21 days before the issuer’s first sale of securities in the crowdfunding transaction.
Ongoing Reporting Requirements
Issuers will be required to file with the SEC and provide to investors reports on their results of operations and their financial statements on a yearly basis. Issuers must file this annual report on EDGAR within 120 days of the end of their most recent fiscal year. Issuers must also place these reports on their websites. The annual reports will provide similar information to the initial disclosures described above.
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. These responsibilities 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 subject to substantial restrictions on their and their employees’ conduct and compensation. Among other things, intermediaries may not have any “financial interest” in the issuer or receive a financial interest in the issuer as a result of the transaction.
Securities Act Liability
In addition to being subject to the general anti-fraud provisions of Section 10(b) of the Exchange Act of 1934 and Section 17 of the Securities Act of 1933 (the “Securities Act”), issuers in crowdfunding transactions will be subject to the “prospectus” liability provisions of Sections 12(b) and 13 of the Securities Act, which 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. In general, it will 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 and burdens that come with the Crowdfunding Exemption will likely make it less attractive to most issuers than the alternative private placement structures available to them.
First, the initial disclosure requirements, particularly the financial statement and audit requirements, will be very difficult for many early-stage companies to satisfy, and even those that can satisfy them may find them prohibitively expensive. The ongoing disclosure requirements only add to this burden. Particularly in light of the $1 million annual cap on all crowdfunding securities sales that the exemption imposes, most issuers are likely to see crowdfunding dollars as, at best, very expensive money.
Second, a successful crowdfunding transaction, by its very nature, will result in a significant number of retail investors owning the issuer’s securities, and most of these new investors will be relative strangers to the issuer. These investors may be unsophisticated, they may not understand, much less share, the issuer’s vision and values, and they may not take action when necessary. Even under the best circumstances, an issuer that raises money through a crowdfunding transaction is likely to find itself devoting far more attention to investor relations than it would if it had raised money through a traditional private placement.
Third, because issuers in crowdfunding transactions are subject to “prospectus” liability on their disclosures, aggrieved investors will likely find it easier to bring and prevail in securities actions against issuers in crowdfunding transactions. As a result of this enhanced liability, coupled with the fact that issuers will find it more difficult to negotiate with investors who are inexperienced or do not know them well, crowdfunding transactions will likely be subject to significantly more litigation risk than other private placements.
Finally, the Crowdfunding Exemption places heavy burdens on intermediaries and offers them relatively limited opportunities to make money on the transactions. Consequently, established investment banks have shown little interest in serving as intermediaries in crowdfunding transactions and have left the field to entities with little experience and relatively limited resources. The registration process should screen out the genuinely bad actors, but there are serious concerns about whether small and inexperienced institutions will be able to perform the substantial gatekeeping responsibilities assigned to them under the Crowdfunding Exemption, much less give issuers the support and guidance they need as they approach the investing public for the first time.
While these concerns are significant, some issuers, especially those that lack the networks typically necessary to support traditional private placements, may find the Crowdfunding Exemption their best, or only, option for selling securities. Such issuers should proceed with caution and, in particular, make sure that they are getting the advice they need to produce disclosures that minimize the risk of liability if their business does not perform as they hope it will.
The proposed rules remain subject to change during the 90-day comment period, and we will provide additional guidance when these rules are finalized. In the meantime, please do not hesitate to contact one of the attorneys listed in this update or your usual Taft contact if you have questions about crowdfunding and how it may be useful to your business.