Introduction

On October 23, 2013, the Securities and Exchange Commission (SEC) voted unanimously to propose rules to permit U.S. companies to offer and sell securities through crowdfunding in an effort to implement the requirements of Title III of the Jumpstart Our Business Startups (JOBS) Act and define the regulatory framework for a new, alternative way for companies to raise money. The SEC will seek public comment on the proposed rules through February 3, 2014. The SEC will then review the comments and determine whether to adopt the proposed rules and publish them in the Federal Register.

Background

Crowdfunding refers to a relatively new and evolving method of raising money through the Internet. An entity or individual that crowdfunds to raise money typically seeks small individual contributions from a large number of persons through an online portal or website. The portal or website provides information about the project, cause, idea or business and facilitates online donations or investments from interested persons. A crowdfunding campaign generally sets a target funding level, a timeframe in which to raise the funds and an identified use of those funds. Over the last several years, crowdfunding websites have been successfully used to fund artistic, musical, business, philanthropic and scientific endeavors, among others.

Crowdfunding generally has not been used in the U.S. to sell financial instruments in exchange for a share of an expected financial return or profit generated from the business activities of the fundraiser because the offer and sale of those instruments would invoke the application of the federal securities laws. Under the Securities Act of 1933 (the Securities Act), the offer and sale of securities is required to be registered unless an exemption from registration is available. Because of the transaction costs and required reporting obligations associated with registered offerings, registering a crowdfunded offer and sale of securities has been considered impracticable. Moreover, purchaser qualification requirements, limitations on general solicitation and advertising and the extensive disclosure obligations required to be provided to unaccredited investors under Regulation D of the Securities Act have made it difficult for crowdfunded transactions to qualify for and comply with an existing private placement exemption. In addition, existing federal securities regulations would require the online portals or platforms acting as intermediaries to facilitate the offer and sale of crowdfunded securities to register with the SEC as a broker and comply with the applicable broker-dealer regulations. Persons operating such websites for startups and small businesses may find it impracticable to register as a broker in light of the limited scale of the business activities involved. 

The U.S. Congress passed the JOBS Act in 2012 partly to address the regulatory burdens facing crowdfunding players and the limited funding opportunities available to small businesses wishing to raise low dollar amounts from a large number of investors while maintaining sufficient investor protections. Title III of the JOBS Act provides an exemption from the registration requirements of Section 5 of the Securities Act for securities-based crowdfunding transactions by adding a new Securities Act Section 4(a)(6). The JOBS Act also exempts intermediaries who are not otherwise subject to broker-dealer registration under the Securities Exchange Act of 1934 (the "Exchange Act") from regulation as brokers and instead provides for a new class of intermediaries, referred to as "funding portals," which are subject to more limited oversight. As such, the JOBS Act established a long-anticipated legal framework permitting crowdfunding transactions and directs the SEC to write the rules regulating such transactions.

The Proposed Rules
 
Consistent with its Congressional mandate, the SEC's proposed rules would govern the offer and sale of securities under the Securities Act, exempt securities sold pursuant to the crowdfunding rules from the registration requirements of the Exchange Act and provide a framework for regulating the registered funding portals and brokers that issuing companies are required to use as intermediaries in the offer and sale of their securities.

Issuer and Investor Qualifications

To qualify for an exemption under Section 4(a)(6), crowdfunding securities-based transactions would have to meet the following requirements:

• An issuer (including any predecessor of the issuer and any company controlled by or under common control with the issuer) would be permitted to raise up to a maximum of $1 million through crowdfunded offerings in any 12-month period. The proposed rules would exclude amounts raised in other exempt offerings from the $1 million issuer limit.¹ Non-securities-based funding (e.g., donations or pre-purchases) also would not count toward this limit. The proposed rules would not eliminate the need for an issuer to comply with integration rules applicable to any concurrent non-crowdfunded exempt offering of securities. For example, a contemporaneous private placement under Rule 506(b) of Regulation D might not satisfy applicable restrictions on general solicitation if investors in the private placement became interested in the private offering as a result of a crowdfunding initiative by the issuer.
• An individual investor would be permitted to invest over a 12-month period, in all crowdfunded offerings:
  • $2,000 or 5 percent of that person's annual income or net worth², whichever is greater, if both the person's annual income and net worth were less than $100,000; or
  • 10 percent of annual income or net worth, whichever is greater (not to exceed $100,000 in total purchases), if either the person's annual income or net worth were equal to or more than $100,000.

The following categories of issuers would not be eligible to rely on the Section 4(a)(6) exemption to conduct crowdfunding transactions: (1) non-U.S.-based businesses, (2) companies obligated to report under the Exchange Act, (3) companies defined as "investment companies" under the Investment Company Act of 1940 or that are excluded from the definition of an investment company under Section 3(b) or 3(c) of the Investment Company Act of 1940 (e.g., most hedge funds), (4) companies that are disqualified from relying on the exemption under proposed disqualification provisions, (5) companies that have failed to comply with the proposed ongoing annual reporting requirements³ within the last two years and (6) companies without a specific business plan or with a business plan that contemplates a merger or acquisition with an unidentified company or companies.

Resale Restrictions

The resale of securities purchased in a crowdfunding transaction would be restricted for a period of one year from the initial purchase. During that period, crowdfunding securities could be transferred only (i) to the issuer, (ii) to an accredited investor, (iii) as part of an offering registered under the Securities Act or (iv) to a family member or trust in connection with the death or divorce of the initial purchaser or other similar circumstances.

Disclosure Obligations

Companies offering or selling securities in reliance on Section 4(a)(6) would need to file specified offering disclosures with the SEC on a new Form C, provide these disclosures to the associated broker or funding portal, and ensure that the disclosures are provided and made available to potential investors. The broker or funding portal would be required to post this information at least 21 days prior to the first sale of securities in the crowdfunding offering. The offering disclosures would be required to include, among other information:

• the name, legal status, physical address and website address of the issuer
• the names of the directors and officers and their positions and business experience during the last three years
• each person holding more than 20 percent of the shares of the issuer, calculated on the basis of voting power
• a description of the issuer's business and anticipated business plan
• a narrative description of the financial condition of the issuer, which would also need to be accompanied by either financial statements and a copy of the issuer's tax returns, or financial statements⁴ reviewed or audited by an independent public accountant, depending on the amount offered and sold during a 12-month time period
• related party transactions
• a description of the intended use of proceeds of the funds raised in the crowdfunding transaction
• the targeted offering amount, deadline to raise the funds and regular updates regarding the progress of the issuer in meeting the targeted amount
• an investor's right to cancel his or her committment within 48 hours of a written deadline set by the issuer
• the public offering price of the securities, or method of determining the price
• a description of the ownership and capital structure of the issuer
• information on all exempt offerings conducted by the issuer within the last three years
• a description of the issuer's material indebtedness, if any
• the compensation paid to the intermediary
• the particular risks of investing in the offering

Material changes to the offering disclosures, which would be reflected in an amendment to the Form C, would require investors to reconfirm their investment commitments within five business days or the investment commitments would be deemed cancelled.

Prohibition on Advertising

The proposed rules would prohibit companies from advertising or marketing the terms of the crowdfunding transaction, except for notices which direct investors to the online broker or funding portal. The notice would be permitted to contain factual information about the company and basic terms of the offering, including: the amount of the securities offered, the nature of the securities, the price of the securities and the closing date of the offering period.

Exchange Act Registration

Holders of crowdfunding securities would not count toward the numeric threshold for registration of a class of securities under Section 12(g) of the Exchange Act.

Crowdfunding Portals

With investor protection in mind, the proposed rules would require that a company relying on the exemption under Section 4(a)(6) conduct its crowdfunding transaction(s) exclusively online through a platform operated by a registered broker or other intermediary registered with the SEC as a "funding portal," a new type of SEC registrant.

Consistent with the JOBS Act definition of a funding portal, the proposed rules would exclude funding portals from engaging in the following activities related to a crowfunding transaction: (1) offering investment advice or recommendations, (2) soliciting, or compensating anyone to solicit, purchases, sales or offers to buy the securities offered through the portal and (3) holding, managing or possessing investor funds or securities. However, the proposed rules would provide a safe harbor under which funding portals could engage in certain activities necessary to execute the crowdfunding transaction and not run afoul of these restrictions.

Crowdfunding intermediaries would be required to, among other things: (1) facilitate the offer and sale of crowdfunded securities and reasonably ensure investor qualifications, (2) make available information about the issuer and the offering, including its compensation in connection with the offering, (3) monitor and provide channels of communication permitting potential investors to discuss and exchange information about crowdfunded offerings through the portal, (4) provide and make available electronic educational materials for investors, and (5) take other measures to reduce the risk of fraud.

Intermediaries would be required to obtain investor consent for electronic delivery only of all offering-related documents, except for some limited, outside communications.

Crowdfunding and State Regulation of Securities

The JOBS Act amends Section 18(b)(4) of the Securities Act to add to the list of covered securities for which state securities law preemption applies, securities offered in crowdfunding transactions exempt under Section 4(a)(6). However, the JOBS Act indicates that no state filing or fee requirements will be required of securities offered in crowdfunding transactions except as may be required by the securities regulator in the state in which the issuer maintains its principal place of business, or in which purchasers of 50 percent or greater of the aggregate amount of the securities issued are residents. Also, the amendment does not limit the states' authority to take enforcement action with regard to an issuer, funding portal, or any other person or entity using the crowdfunding exemption from registration for fraud, deceit, or unlawful conduct.

The JOBS Act also amends Section 15(i) of the Exchange Act to generally preempt state regulation of registered funding portals, but retains the enforcement and examination authority of the state in which the principal place of business of a registered funding portal is located, provided that such state's applicable law, rule, regulation or administrative action is not in addition to or different from the requirements for registered funding portals established by the SEC.

Looking Forward

The SEC will seek public comment on the proposed rules through February 3, 2014. After the conclusion of the comment period, the SEC will review the comments received and determine whether to adopt the proposed rules. If adopted, the proposed rules will be published in the Federal Register. 

¹ The proposed rules resolve a significant ambiguity in the drafting of the JOBS Act crowdfunding provisions in this regard.
² The proposed rules would require a natural person's annual income and net worth to be calculated in accordance with the SEC's rules for determining accredited investor status. See Rule 501(a) of Regulation D.
³ Companies that conduct an offering in reliance on the crowdfunding exemption would be required to file annual reports, complete with financial statements, with the SEC, and post the reports on their websites.
⁴ The financial statements would need to be prepared in accordance with Generally Accepted Accounting Principles (GAAP) and cover the shorter of either the two most recently completed fiscal years or since the business' inception.