Over the next several weeks, we'll explore Regulation Crowdfunding and its provisions before the final rules become effective on May 16, 2016.
As directed by Congress under the JOBS Act of 2012, the Securities and Exchange Commission (“SEC”) recently adopted final rules to permit equity “crowdfunding,” characterized by the SEC as “a relatively new and evolving method of using the Internet to raise capital to support a wide range of ideas and ventures.”1 The final rules, referred to as “Regulation Crowdfunding,” were published in the Federal Register on November 16, 2015, and become effective May 16, 2016.
This three-part blog post contains a summary of the new rules.
Overview of Regulation Crowdfunding
In contrast to an Internet service like Kickstarter, which permits investors to invest funds in exchange for the promise of goods or services, Regulation Crowdfunding will permit the purchase and sale of debt and/or equity securities. Unlike certain other securities offering exemptions, such as Rule 506 of Regulation D, there are no restrictions under Regulation Crowdfunding on participation by unaccredited investors. As discussed below, however, Regulation Crowdfunding includes a number of provisions intended to protect investors who engage in these transactions, including investment limits, required disclosures by issuers and a requirement to use regulated intermediaries.
Generally under Regulation Crowdfunding, an issuer may raise up to $1,000,000 in a 12-month period through crowdfunded offerings. An issuer engaging in a crowdfunded offering must complete and file the newly-created Form C, which requires the public disclosure of certain business and financial information of the issuer, including financial statements prepared in accordance with U.S. GAAP.
Conducting a Crowdfunded Offering
Individual Investment Limitations
On the investor side, the amount an individual may invest across all crowdfunded offerings in which the investor participates during any 12-month period will depend on the individual’s annual income or net worth:
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An individual with an annual income or net worth less than $100,000 may invest the greater of $2,000 or 5% of the lesser of their annual income or net worth; and
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An individual with an annual income or net worth equal to or over $100,000 may invest 10% of the lesser of their annual income or net worth, subject to a maximum aggregate investment of $100,000.2
Capital Limits on Crowdfunding Activities
While Regulation Crowdfunding limits issuers to raising $1,000,000 in a 12-month period, only capital raised in reliance on the crowdfunding exemption will be counted towards the limit although the amount of securities sold by entities controlled by or under common control with the issuer must be aggregated with the amount to be sold by the issuer, as well as any amounts sold by a predecessor of the issuer.3 Issuers will be permitted to conduct a concurrent exempt offering under another available exemption during a crowdfunded offering as long as the issuer complies with the respective rules applicable to each offering. Note, however, that a concurrent exempt offering involving general solicitation would be subject to the advertising restrictions described below.
Mandatory Use of Crowdfunding Intermediaries
As required by the JOBS Act, all transactions relying on Regulation Crowdfunding must take place on an Internet platform, exclusively through an SEC-registered “intermediary,” which can be either a registered broker-dealer or a “funding portal.”4 An issuer relying on Regulation Crowdfunding may only conduct a crowdfunded offering through one intermediary’s platform at a time. Regulation Crowdfunding will require intermediaries to, among other items:
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Provide potential investors with educational materials on the use of the intermediary’s platform, the securities being offered and the issuer;
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Provide communication channels to permit discussions about the offering on its platform;
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Disclose the source, form and amount of any compensation the intermediary receives in connection with the offering;
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Take certain measures to reduce the risk of fraud, including having a reasonable basis for believing that an issuer is complying with Regulation Crowdfunding, that an issuer has established means to keep accurate records of its securityholders and that any potential investor complies with applicable investment limitations;
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Not permit any of its directors, officers or partners to have any financial interest in the issuer or itself receive a financial interest in the issuer as compensation for services provided to the issuer in connection with the offering (subject to limited exceptions).5
These requirements suggest that intermediaries will have to operate fee-for-service crowdfunding businesses that will impose meaningful out-of-pocket expenses on issuers. Of course it is too early to predict the extent to which a funding portal industry will develop or the extent to which registered broker-dealers will be willing to provide intermediary services.
Advertising Restrictions and Limitations on Other Public Announcements
Advertising outside of the intermediary’s Internet platform for crowdfunding is limited under Regulation Crowdfunding. Any advertisement or public announcements made in connection with a crowdfunded offering, whether made directly by the issuer or indirectly by anyone acting on behalf of the issuer, must be limited to:
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A statement that the issuer is conducting an offering, the name of the intermediary through which the offering is being conducted and a link to its platform;
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The terms of the offering (limited to amount of securities offered, nature of securities, price and closing date); and
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The name, address, phone number and website of the issuer, as well as the e-mail address of a representative of the issuer and a brief description of the business of the issuer.6
Regulation Crowdfunding does permit an issuer to communicate with investors about itself and the offering through the intermediary’s platform, so long as the issuer identifies itself in all such communications. Other than the identification requirement, Regulation Crowdfunding does not restrict issuers from participating in such communications.7 However, we would counsel issuers to carefully evaluate them under the same standards of accuracy and truthfulness used for other publicly-available communications, to protect against potential securities fraud claims.
If an issuer hires a promoter to promote an offering in intermediary communication channels, the issuer must take steps to ensure that the promoter clearly discloses the receipt of compensation each time the person makes a promotional communication and if the promoter’s communications occur outside of the intermediary’s platform they will be subject to the same content restriction that issuers face.8
Minimum Offering Timeline and Commitment Cancellations
Offerings must be held open for a minimum of 21 days during which investment commitments may be accepted. Potential investors are permitted to cancel their investment commitments until 48 hours prior to the deadline specified by the issuer for any reason. Within the final 48 hours prior to the deadline investors may only cancel their commitments if there is a material change in the offering or the issuer’s business as described below.
Limitations on Resale of Crowdfunded Securities
Securities sold in a crowdfunded offering generally may not be resold for a one-year period, unless the securities are transferred:
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To the issuer;
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To an accredited investor;
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As part of an offering registered with the SEC; or
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To a member of the family of the purchaser, to a trust controlled by the purchaser or created for the benefit of a family member, or in connection with the death or divorce of the purchaser.9
State Blue Sky Requirements
Crowdfunded offerings will not be subject to state registration requirements under so-called “blue sky” laws.
1 See Crowdfunding, Final Rule, Release Nos. 33-9974; 34-76324; File No. S7-09-13 at 6.
2 Annual income and net worth should be calculated in the same manner in which they are calculated for purposes of determining accredited investor status under Rule 501 of Regulation D. Id. at 27, 548.
3 See id. at 18-19.
4 A funding portal will be required to register with the SEC and FINRA, but will not be able to conduct certain activities that registered broker-dealer may, such as offering investment advice or making recommendations, soliciting purchase, sales or offers to buy securities, and holding, possessing or handling investor funds or securities. See id. at 151-53. The registration process and FINRA requirements for funding portals are outside the scope of this post. Potential funding portals will be able to begin registration beginning January 29, 2016.
5 See id. at 151-81.
6 See id. at 136-142.
7 “We believe that one of the central tenets of the concept of crowdfunding is that the members of the crowd decide whether or not to fund an idea or business after sharing information with each other. As part of those communications, we believe it is important for the issuer to be able to respond to questions about the terms of the offering or even challenge or refute statements made through the communication channels provided by the intermediary.” Id. at 141.
8 See id. at 195-99.
9 See id. at 324-27.
Stay tuned for Part II of this three-part blog post.
