Small Business Securities Bulletin: By Popular Demand - SEC Proposes Crowdfunding Rules

by Baker Donelson

A periodic bulletin keeping small businesses informed about current developments in securities law and related matters.

By way of background, pursuant to Section 5 of the Securities Act of 1933 (Securities Act) and state securities laws, any offer and sale of a security must be registered with the Securities and Exchange Commission (SEC) and any applicable state securities regulators, or exempt from such registration. On the heels of its adoption in July of rules that allow for wide and public solicitation and advertising in certain exempt private offerings, and pursuant to new Sections 4(a)(6) and 4A of the Securities Act, as added by Title III of the Jumpstart our Business Startups (JOBS) Act, the SEC has proposed its much-anticipated rules that would exempt from registration certain sale of securities via “crowdfunding.” According to the proposing release, available here [PDF], “[c]rowdfunding is a new and evolving method to raise money using the Internet. Crowdfunding serves as an alternative source of capital to support a wide range of ideas and ventures.” According to the release, “[a] crowdfunding campaign generally has a specified target amount for funds to be raised, or goal, and an identified use of those funds” and “typically seeks small individual contributions from a large number of people.” Currently, crowdfunding campaigns offer contributors a sample of the item the company seeking the capital is developing or, for example, in the case of a crowdsourcing campaign to produce a movie, a credit in the movie or tickets to the premier. However, such crowdfunding campaigns cannot offer stock or other equity in the company raising the funds as that would implicate federal and state securities laws, and crowdfunding does not currently qualify for an exemption from registration under such laws. In accordance with the JOBS Act, the dollar figures in the proposed rules would be subject to periodic adjustment for inflation.

Under the proposed rules, in order to qualify for the crowdfunding exemption issuers would have to (i) comply with specified requirements, including limits on the amount raised from any one investor and by the issuer in any 12-month period, (ii) conduct the offering through a registered intermediary, (iii) comply with the rule’s informational requirements, and (iv) comply with certain other requirements set forth in the proposed rule. This Bulletin discusses the requirements of the proposed crowdfunding exemption in more detail below.

Pursuant to Section 18(b)(4)(B) of the Securities Act, securities sold in a crowdfunding offering under the new rules would be exempt from state registration, subject to any state requirements to file any documents submitted to the SEC in this regard, including annual reports, discussed below.

One Million Dollar Offering Limit

Consistent with Section 4(a)(6), the proposed rules limit the amount an issuer may raise under the crowdfunding exemption to $1 million in any 12-month period. The proposing release makes clear, however, that the limit applies only to offerings under the proposed crowdfunding exemption, and that amounts raised through other methods, such as an exempt private placement conducted under Regulation D of the Securities Act or through non-securities based crowdfunding efforts, will not count towards the $1 million limit. The amount sold in reliance on the exemption by entities controlled by or under common control with the issuer, or any predecessor of the issuer, within the prior 12 months will, however, count towards the $1 million limit. Crowdfunding offerings will not be integrated with other exempt offerings by the issuer, assuming that each offering complies with the requirements of the applicable exemption being relied upon. Issuers will need to take care, however, to ensure that persons investing in an exempt offering that does not permit general advertising and general solicitation that is concurrent with a crowdfunding offering were not solicited by means of the crowdfunding offering.

Investment Limits

Under the proposed rules, the aggregate amount of securities sold by an issuer to any one investor during any 12-month period may not exceed the greater of (i) $5,000 or 5% of the investor’s annual income or net worth, whichever is greater, if the investor’s annual income and net worth are below $100,000 or (ii) 10% of the investor’s annual income or net worth, whichever is greater, not to exceed $100,000, if the investor’s annual income or net worth are at least $100,000. Income and net worth are calculated consistent with the SEC’s definition of an accredited investor as set forth in Rule 501 of Regulation under the Securities Act and, therefore, may be considered alone or with the investor’s spouse and the investor’s primary residence must be excluded from the net worth calculation. Further, under the proposal issuers could rely on efforts that an intermediary takes in order to determine that the aggregate amount of securities purchased by an investor will not cause the investor to exceed the limits, as long as the issuer has no knowledge of the contrary. There are no other purchaser requirements under the proposed rules; for example, investors need not be accredited investors or have any knowledge or experience in business or financial matters.


As noted above, to qualify for the crowdfunding exemption, a securities offering must be conducted solely through online platforms operated by a registered intermediary that complies with Section 4A of the Securities Act and otherwise complies with the requirements of the proposed rule. Issuers may not use more than one intermediary to conduct a crowdfunding offering or concurrent offerings. Consistent with the general understanding of crowdfunding, offerings under the proposed rules could not take place off-line, although issuers may provide notice, consistent with the conditions of the proposed rule, directing potential investors to the intermediary’s platform, through other means.

Pursuant to Sections 4(a)(6) and 4A of the Securities Act, an intermediary must be a registered broker or a “registered funding portal.” Funding portals are limited to acting as intermediaries in crowdfunding offerings and cannot offer investment advice, solicit purchases, hold or handle investor funds or securities, or take certain other prohibited actions in connection with securities offerings. The proposed rules set forth the requirements and means for such funding portals to register with the SEC through a new Form Funding Portal; funding portals must also register with FINRA or another registered national securities association that may exist in the future. Funding portals would be subject to SEC examination and enforcement, be required to implement policies and procedures designed to achieve compliance with the federal securities laws and applicable regulations thereunder, and have to comply with certain recordkeeping, anti-money laundering and Bank Secrecy Act, and other ongoing requirements as set forth in the proposed rules. The proposed rules set forth additional activities that may and may not be undertaken by funding portals, a discussion of which is beyond the scope of this Bulletin.

Consistent with Section 4A of the Securities Act, the proposed rules set forth actions intermediaries must take with respect to their role in crowdfunding. As set forth therein, funding portals, among other things, must: (i) provide investors with investor-education materials, ensure that each investor affirms that the investor understands that the investor is risking the loss of its entire investment, that the investor could bear such a loss, and ensure that the investor understands certain risks in connection with the offering; (ii) make information required to be provided by the issuer, as discussed below, available to investors and the SEC on its platform at least 21 days before any securities are sold; (iii) take steps to reduce fraud with respect to crowdfunding transactions, including having a reasonable basis to believe that the issuer is in compliance with all relevant regulations and has the means to keep accurate records, conducting background checks to ensure that the issuer (and its related persons) is not subject to the disqualification provisions discussed below, and prohibiting the issuer from using its platform if it becomes aware of a disqualification or other information that it believes presents the potential for fraud; (iv) take steps to ensure that investors do not exceed the investment limits of the rule, and have a reasonable basis to believe (including through the investor’s representation to that effect), before allowing an investor to invest though its platform, that the investor satisfies the investment limitations discussed above; (v) electronically deliver required investor education materials (including about risks of investing and the circumstances under which an investor may cancel an investment), notices and confirmations; (vi); before accepting an investment commitment, obtain a representation from the investor that it has reviewed the educational materials, understands that the entire amount of his or her investment may be lost and is in a financial condition to bear such loss, and a questionnaire from the investor that the investor understands there are restrictions on the investor’s right to cancel their commitment, it may be difficult to resell the securities purchased and the investment involves risk; (vii) provide on its platform communication channels by which potential investors can communicate with each other and with representatives of the issuers making offerings through the intermediary’s platform; (viii) comply with rules for the maintenance and transmission of investor funds in any offering through its platform (funding portals cannot receive funds and would have to direct investors to transmit funds to a qualified bank), including transmitting (or directing the transmission of) funds to the issuer only after the target offering amount is met or exceeded (but not before 21 days after the intermediary has posted the required information about the offering and the cancellation period has elapsed); (ix) provide investors with a notice of investment commitment upon receipt of an investment commitment from an investor; and (x) provide investors with confirmation of the transaction, including the identity, price and number of securities purchased by the investor and sold in the offering, the purchase price, and the source and amount of any remuneration received by the intermediary in connection with the transaction.

With respect to communication channels, an intermediary that is a funding portal would be prohibited from participating in any communications in these channels, apart from establishing guidelines for communication and removing abusive or potentially fraudulent communications.

Issuer Requirements; Disqualification

Only U.S. issuers that are not required to file reports with the SEC under the Securities Exchange Act of 1934 (Exchange Act) would be permitted to conduct an offering under the proposed crowdfunding exemption. Investment companies, companies excluded from the definition of an investment company pursuant to certain exclusions from the definition (including hedge funds and other private funds), companies that had utilized the crowdfunding exemption but failed to file the required annual report with the SEC in the prior two years and companies with no specific business plan or whose business plan is to merge with or acquire an unidentified company or companies, would also be ineligible to conduct such an offering. Finally, the proposed rules provide that an issuer may not conduct an offering under the proposed exemption if (i) the issuer, (ii) an affiliated or predecessor issuer, (iii) its officers, directors or stockholders owning 20% or more of its voting securities, (iv) any promoter of the issuer, or (v) any person that has or will be compensated in the offering (or its directors, officers, general partners or managing members), have been convicted of certain felonies and misdemeanors, are subject to certain court or regulatory orders, bars, judgments or decrees, or filed or was named as an underwriter in any registration statement or Regulation A offering statement with the SEC that was subject to a refusal order, stop order or order suspending the regulation A exemption. For criminal convictions and certain orders, judgments and decrees, the look-back period for such events is either five or ten years, but others will result in a disqualification if the applicable person or entity remains subject to the order, etc. at the time of sale. In either case, the disqualification will not apply if the triggering event took place before the effective date of the final rules. Issuers will have to disclose in their offering materials, however, any such event that would have triggered the disqualification but for the fact that the event took place before the effective date of the rules. In addition, the disqualification will not apply if the authority issuing the relevant judgment, order or other triggering directive advises the SEC, either in such order, judgment, etc. or by direct communication to the SEC, that disqualification should not be a consequence of the order, judgment or other action. The disqualification also will not apply if waived by the SEC (by delegation to the Director of the Division of Corporation Finance) “upon a showing of good cause” or “[i]f the issuer establishes that it did not know and, in the exercise of reasonable care, could not have known that a disqualification existed.” Therefore, an issuer conducting a crowdfunding offering would need to make factual inquiries to confirm that no disqualification exists. Similar disqualification provisions also apply to intermediaries.

Disclosure Requirements

Consistent with Section 4A of the Securities Act, the proposed rules require issuers conducting an exempt crowdfunding offering to file certain information with the SEC through its EDGAR filing system and provide it to the intermediary, who would then make it available to investors and potential investors through the intermediary’s platform. This information would be disclosed on a new Form C. Form C would require the issuer to disclose certain information about: (i) the issuer and its officers, directors and persons that beneficially owns 20% or more of its outstanding voting securities; (ii) its business and business plan; (iii) the intended use of proceeds of the offering; (iv) the target offering amount, the deadline to reach such target, and whether the issuer will accept subscriptions in excess of the target amount and the maximum amount it will accept, and how it will allocate oversubscriptions; (v) the offering price; (vi) the terms of the securities being offered and other information regarding the issuer’s ownership and capital structure; (vii) a discussion of the material factors that make an investment in the issuer speculative or risky; (viii) indebtedness of the issuer; (ix) other exempt offerings conducted by the issuer in the past three years; (x) certain related-party transactions; and (xi) similar to the Management’s Discussion and Analysis required for registered offerings, a description of the issuer’s financial condition, “including, to the extent material, … the issuer’s historical results of operations, liquidity and capital resources.” Issuers would also be required to disclose that investors may cancel an investment commitment until 48 hours prior to the deadline disclosed in the offering materials, that the intermediary will notify investors when the target offering amount has been reached, and disclosures regarding closing the offering early if the target amount is reached, the need for an investor to reconfirm its investment after a material change to the offering, and that the offering will be canceled if the target amount is not reached by the offering deadline. Issuers would also be required to inform investors that the securities purchased would be restricted from resale or other transfer for one year, as well as the name of and amount of compensation paid to the intermediary in the offering. The proposed rules also would require that certain legends be included in the offering materials.

In addition, issuers would be required to provide certain financial information in the Form C, depending on the amount of capital being raised in the current offering and raised in all other crowdfunding offerings under Section 4(a)(6) in the prior 12 months, as follows: (i) up to $100,000, the issuer’s most recent tax return and financial statements for the last two fiscal years certified by its principal executive officer to be true and complete; (ii) greater than $100,000 but no more than $500,000, financial statements reviewed by an independent certified public accountant (CPA); and (iii) greater than $500,000, financial statements audited by an independent CPA. Such financial statements must cover a two-year period or, if shorter, the period since inception. The independent CPA need not be registered with the Public Company Accounting Oversight Board, and the CPA’s review or audit report must accompany the financial statements.

Issuers would also be required to prepare regular updates on its progress in meeting the target offering amount, and amend its disclosure for any material changes to the terms of the offering or the disclosure previously provided, which would be filed with the SEC and provided to investors and the intermediary and made available to potential investors.

Advertising; Compensation

Under the proposed rules, advertising of crowdfunding offerings would be limited to notices that provide very limited information about the offering and the issuer and direct potential investors to the intermediary’s platform. Issuers and their founders and employees, or other persons engaging in promotional activities on behalf of the issuer, could also communicate with potential investors about the terms of the offering through communication channels provided by the intermediary, but must identify themselves in each such communication. Compensation paid to any person to promote the offering through such channels, or promotion by a founder or employee of the issuer, must be clearly disclosed each time such person makes a promotional communication.

In addition, under the proposed rules intermediaries could not compensate any person for providing it with “personally identifiable information” of any investor or potential investor. The proposed rules would permit an intermediary to compensate persons for directing issuers or potential investors to the intermediary’s platform if the person does not provide the intermediary with personally identifiable information of any potential investor and the compensation is not based on the purchase or sale of a security offered through the intermediary’s platform, unless paid to a registered broker or dealer. Further, neither an intermediary nor any of its directors, officers or partners could have or receive as compensation a financial interest (i.e. equity) in any issuer offering and selling securities through its platform.

Completion, Amendment, Cancellation and Reconfirmation

Under the proposed rules, investors may cancel their commitments at any time until 48 hours before the expiration date of the offering disclosed in the offering materials. The issuer can close the offering early if the target investment is reached prior to the expiration date if the offering would have remained open for at least 21 days, the issuer provides notice of the new offering deadline and investors are given the opportunity to cancel their investment commitment until 48 hours before the new deadline, as long as the issuer continued to meet the target investment amount.

If there is a material change to the terms of the offering or the offering information, the proposed rules would require the intermediary to give or send to potential investors who have made investment commitments notice of the change and informing investors that their commitment will be cancelled unless they reconfirm their commitment within five business days of receipt of the notice.

If an issuer cancels an offering, the intermediary must send a notice of cancellation within five business days and return or direct the return of the investors’ funds.

Restrictions on Resale

The proposed rules would prohibit the resale or other transfer of securities sold in a crowdfunding offering for one year from the date of purchase except for transfers: (i) to the issuer; (ii) to an accredited investor; (iii) as part of a registered offering; (iv) to a family member (as defined in the proposed rules); and (v) to a trust controlled by the initial purchaser or created for the benefit of a family member, or in connection with the death or divorce of the purchaser or other similar circumstance.

Ongoing Reporting Requirements

Issuers that sell securities pursuant to an offering under the new exemption would have to file annual reports with the SEC, and post on their Web site, on a Form C-AR that includes the information required by Form C, except the offering-specific information, including updated financial statements and discussion of its financial condition. Such an issuer would be required to file the annual report until (i) it becomes an SEC reporting company, (ii) all the securities issued under the exemption are repurchased, or (iii) it dissolves or liquidates.

Exchange Act Registration Exemption

Security holders of an issuer who own securities initially sold by the issuer solely under the new crowdfunding exemption would not count towards the number of record holders (2,000 or 500 who are not accredited investors, or 2,000 for banks and bank holding companies) that trigger SEC registration and reporting under Section 12(g) of the Exchange Act.


In the proposing release, the SEC has asked for comments on almost 300 specific questions, as well as comments in general on the proposal, so the final rules are likely to contain some changes from the proposal, though we expect the general structure of the proposed crowdfunding exemption to remain intact. Comments are due February 3, 2014. Further, the SEC will “monitor the market for offerings made in reliance on” the new exemption with the intention of considering necessary amendments, so there may be changes after adoption as well.

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.

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