SEC Proposes Crowdfunding Rules

by Pepper Hamilton LLP
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This article was originally published on October 23, 2013 as a guest post on Forbes.com.

In an important first step towards regulating businesses that fund their ventures online, the Securities and Exchange Commission (SEC) unanimously approved the proposal of rules that will govern the subject. The full text of the SEC’s proposed crowdfunding rules, may be obtained here as a PDF.

Crowdfunding – raising money online to fund projects, causes and even companies – to the public has been stuck in an odd state of limbo after receiving the thumbs-up in early 2012 from the Jumpstart Our Business Startups Act, or JOBS Act. Meanwhile, it has become white-hot with popularity, with Web sites like Kickstarter, Indiegogo and Prosper turning into household names.

The JOBS Act, which passed 390-26 in the House and 73-26 in the Senate, was designed to ease restrictions on capital raising across a broad spectrum of finance, from IPOs to private placements and start-up seed financing. It left regulation to the SEC, where the subject has been mired in rulemaking delays. Crowdfunding remains one of the last provisions of the JOBS Act to be implemented.

The proposal comes with a 90-day comment period, followed by another meeting of the SEC to give the final OK. That means we should see the equity crowdfunding rules finalized by sometime in February, 2014. The SEC meeting will be accompanied by an adopting release that gives general guidance on the final rules, summarizes comments received and highlights any deviations from the proposal.

Under the JOBS Act, the SEC was to propose equity crowdfunding rules by Dec. 31, 2012. Its delay is puzzling, since the proposed rules are a virtual reprint of the parameters outlined in the JOBS Act. Here’s a summary of the proposed rules:

  • Crowdfunding caps an amount an issuer can raise to $1 million in any 12-month period.
  • Crowdfunding caps the amount a person can invest in all crowdfundings over a 12-month period at 10 percent of annual income or net worth (incomes of $100,000 or more) or the greater of $2,000 or 5 percent of annual income or net worth (incomes of less than $100,000).
  • Crowdfunding must be done through a registered broker-dealer or registered “funding portal.” Broker-dealers and funding portals may not solicit investments, offer investment advice or compensate employees based on sales. Traditional investment banks have not yet registered for crowdfunding, leading to speculation that crowdfunding will be facilitated by lesser-known financial institutions with little or no retail investment track record.
  • Crowdfunding requires a disclosure document to be filed with the SEC at least 21 days prior to first sale, and requires scaled financial disclosure, including audited financial statements for raises of more than $500,000.
  • Unlike Regulation D Rule 506 private placements to accredited investors following the JOBS Act, crowdfunding does not allow advertising except solely to direct investors to the appropriate broker/funding portal.
  • Annual reports and possibly more frequent reports (depending on SEC rulemaking) must be filed with the SEC by a company that completes a crowdfunding round.

The proposed rules are extremely impractical because of the restrictions and procedural hurdles a crowdfunding issuer, investor and funding portal will have to endure to raise capital. Compared to other forms of crowdfunding and capital raising, equity crowdfunding to the public has the worst “bang for your buck” in all of corporate finance.

One might expect that many of the investable start-ups who do not seek or obtain venture capital financing will resort to crowdfunding to accredited investors – which are generally people with at least $200,000 of gross income per year–$300,000 for a married couple or $1 million net worth. Web sites are already lined up to facilitate this process. Another provision of the JOBS Act that went into effect Sept. 23 enables advertising and “general solicitation” of accredited investor transactions.

Let’s not forget costs, too. To produce an offering disclosure document, enlist a funding portal, run background checks and file an annual report with the SEC year after year might well cost upwards of $100,000. The high expenses compared to the low maximum amounts that can be raised by a company and invested by an individual make public equity crowdfunding one of the costliest forms of (legal) capital raising.

Ironically, the amendments to restrict crowdfunding in the Senate before passage of the JOBS Act have actually made it more risky. Start-ups by their nature are risky. Excluding start-ups that receive venture funding and excluding start-ups that engage in accredited investor crowdfunding leaves the firms will no other option. Unfortunately, add a quotient of fraud that sometimes accompanies online transactions and you have the recipe for a train wreck. (See “JOBS Act Gives Full Employment to Journalists.”)

In order for equity crowdfunding to the public to serve as a useful tool, as intended, Congress needs to amend the JOBS Act to make it less onerous and costly. Unfortunately, the SEC’s hands are tied since the JOBS Act itself creates most of the restrictions in the proposed rule. The SEC, for its part, did not tighten restrictions from the JOBS Act. This might be signal that even the SEC thinks the JOBS Act is too restrictive. Time will tell.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Pepper Hamilton LLP | Attorney Advertising

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