On October 24, 2013, in accordance with Title III of the Jumpstart Our Business Startups Act (the “JOBS Act”), the Securities and Exchange Commission (the “SEC”) issued a press release and published long-awaited proposed rules (Release Nos. 33-9470; 34-70741) (the “Proposed Rules”) to permit companies to offer and sell securities through crowdfunding (“Regulation Crowdfunding”).
Crowdfunding involves the use of the internet and social media to raise capital, typically from a large number of people and in relatively small amounts per person. Historically, crowdfunding could not be conducted in exchange for securities. Instead, companies have been giving their products or other benefits to their investors in exchange for the funds they receive.
When it passed the JOBS Act last year, Congress added Section 4(a)(6) to the Securities Act of 1933 to create an exemption to permit securities-based crowdfunding. In May 2012, the SEC published responses to frequently asked questions related to crowdfunding intermediaries which can be found here. However, as the SEC noted in an announcement on April 23, 2012, issuers may not rely on the new crowdfunding exemption until the SEC adopts final rules to implement the exemption. The Proposed Rules are another step forward in the process to allow companies to engage in securities-based crowdfunding.
How may companies engage in crowdfunding?
In order to more effectively protect investors, Title III of the JOBS Act provides that crowdfunding transactions must take place through an SEC-registered intermediary, either a broker-dealer or a funding portal. Under the Proposed Rules, the offerings would be conducted exclusively online through a platform operated by a registered broker or a funding portal, which will be a new type of SEC registrant.
Additionally, the Proposed Rules would prohibit a company from using more than one intermediary to conduct an offering or concurrent offerings made in reliance on Section 4(a)(6).
How may companies promote their crowdfunded offerings?
Companies would not be able to advertise the terms of the offering except for notices which direct investors to the funding portal or broker. The SEC noted that limiting the advertising of the terms of the offering to the information permitted in the notice is intended to direct investors to the intermediary’s platform and to make investment decisions with access to the disclosures necessary for them to make informed investment decisions. The permitted notices would be similar to the “tombstone ads” permitted under Securities Act Rule 134, except that the notices would be required to direct investors to the intermediary’s platform, such as by including a link directing the potential investor to the platform (“Issuer Notices”). The Proposed Rules would permit companies to distribute compliant notices about the offering through all channels of communication.
What is the maximum amount that a company can raise?
Under the Proposed Rules, a company would be able to raise a maximum aggregate amount of $1 million through crowdfunding offerings in a 12-month period. Capital raised through other means or in reliance on other exemptions would not be counted in determining the aggregate amount sold in reliance on Section 4(a)(6). Thus, a company could complete an offering made in reliance on the crowdfunding exemption that occurs before, after, or simultaneously with, another exempt offering.
How much would each individual investor be able to contribute?
Over the course of a 12-month period, investors would be able to contribute up to:
- $2,000 or 5% of their annual income or net worth, whichever is greater, if both their annual income and net worth are less than $100,000
- 10% of their annual income or net worth, whichever is greater, if either their annual income or net worth is equal to or more than $100,000. During the 12-month period, investors in this category would not be able to purchase more than $100,000 of securities through crowdfunding.
In both instances, the investor’s annual income and net worth may be calculated jointly with the income and net worth of the investor’s spouse. The Proposed Rules would also allow individuals to self-certify their income and net worth and the amount of their other crowdfunding investments for purposes of the individual investor limits.
Both limitations listed above would apply to all investors, including retail, institutional or accredited investors and both U.S. and non-U.S. citizens or residents.
Would all companies be eligible to utilize Regulation Crowdfunding?
No. The following companies would be ineligible to:
- non-U.S. companies
- companies that already are SEC reporting companies
- certain investment companies
- companies that are disqualified under the disqualification provisions of Section 302(d) of the JOBS Act
- companies that have failed to comply with the annual reporting requirements in the Proposed Rules (as described below)
- companies that have no specific business plan or have indicated their business plan is to engage in a merger or acquisition with an unidentified company or companies, e.g., so-called blank check companies
Will a company be able to compensate someone for the promotion of the offering through the intermediary?
The Proposed Rules would prohibit a company from compensating, directly or indirectly, anyone to promote the company’s offering through communication channels provided by the intermediary unless the company takes reasonable steps to ensure that the person clearly discloses the receipt (both past and prospective) of compensation each time the person makes a promotional communication.
The Proposed Rules also specify that companies shall not compensate, directly or indirectly, anyone to promote its offerings outside of the communication channels provided by the intermediary, unless the promotion is limited to Issuer Notices.
What would the intermediaries be required to do?
Under the Proposed Rules, the intermediaries would be required to, among other actions:
- Provide investors with educational materials and ensure that investors understand the risks of the investment
- Take measures to reduce the risk of fraud
- Make available information about the issuer and the offering
- Provide communication channels to permit discussions about offerings on the platform
- Facilitate the offer and sale of crowdfunded securities
What actions may the funding portals not take?
The Proposed Rules would prohibit funding portals from:
- Offering investment advice or making recommendations
- Soliciting purchases, sales or offers to buy securities offered or displayed on its website
- Imposing certain restrictions on compensating people for solicitations
- Holding, possessing, or handling investor funds or securities
However, the Proposed Rules would provide a safe harbor under which funding portals can engage in certain activities consistent with these restrictions.
What disclosures would be required?
The Proposed Rules would require companies conducting a crowdfunding offering to file certain information with the SEC on a Form C. Companies would also have to provide the information to investors, the relevant intermediary facilitating the offering, and potential investors.
Companies would have to provide the following information in their offering documents and in their Form C, among other things:
- Information about the officers and directors as well as shareholders that own 20% or more of the company
- A description of the company’s business and the use of proceeds from the offering
- The price of the securities being offered, the target offering amount, the deadline to reach the target offering amount, and whether the company will accept investments in excess of the target offering amount – note that the issuer is not required to fix the offering price until 5 days prior to the sale of the securities.
- Certain related-party transactions
- A description of the financial condition of the company
- Financial statements of the company that would have to be accompanied by a copy of the company’s tax returns or reviewed or audited by an independent public accountant or auditor, depending on the amount the issuer has sold in the prior 12-month period aggregated with the current offering.
- The process for cancelling an investment commitment or to complete the transaction
- A statement that investors may cancel an investment commitment until 48 hours prior to the deadline identified in the issuer’s offering materials, and a statement that if the company reaches the target amount prior to the identified deadline, it may close the offering early if it provides notice about the new offering deadline at least five days prior to the new deadline
- Disclosure of the material factors that make an investment in the company speculative or risky, including the material terms of any indebtedness of the issuer
Companies may choose to disclose more information if they believe that it is necessary.
How must this information be disclosed?
The Proposed Rules require disclosure through the internet but do not obligate companies to send paper copies of the offering documents to prospective investors. The Form C would require certain disclosures to be presented in a specified format while allowing the issuer to customize the presentation of other disclosures, as the SEC expressed that a company and the intermediary would determine the format that best conveys the other information that the issuer determines is material to investors.
Companies would be required to amend the offering document to reflect material changes and to provide updates on the company’s progress toward reaching the target offering amount within five business days of the company reaching particular intervals. If the update reflects material changes, the company would need to reconfirm the investment interest of the potential investor. For instance, if the company fixes the price of its securities after it initially files the Form C, it would need to amend the Form C to disclose the price and reconfirm the investment interests of its investors.
Most significantly, the Proposed Rules would require a company utilizing Regulation Crowdfunding to file an annual report of the results of operations and financial statements of the company with the SEC and post it on its website.
When could the securities be resold?
As mandated by Title III of the JOBS Act, securities purchased in a crowdfunding transaction are “restricted securities” and may not be resold for a period of one year. Holders of these securities would not count toward the threshold that requires a company to register with the SEC under Section 12(g) of the Securities Exchange Act of 1934.
What could the Proposed Rules mean for startups?
The Proposed Rules bring startups one step closer to being able to engage in securities-based crowdfunding. However, the restrictions and reporting requirements surrounding the new exemption may prove to be too burdensome for companies already operating on a shoestring budget. A historic precedent for this problem is Regulation A, which has been under-utilized since its inception due to the significant cost of the required disclosures when compared to the amount that could be raised.
What’s Next?
The SEC is seeking public comment on the Proposed Rules for 90 days after the publication of the Proposed Rules in the Federal Register. The SEC will review the comments and determine whether to adopt the Proposed Rules as proposed, or to amend them or to propose different rules. Companies wishing to influence the outcome of the final regulations are urged to review the Proposed Rules and timely submit any comments here.
For any questions or more information on these or any related matters, please contact any attorney in the firm’s corporate practice group. A list of such attorneys can be found here. John Hempill (212-634-3073, jhempill@sheppardmullin.com) and Lauren Lewis (650-815-2672, lalewis@sheppardmullin.com) participated in drafting this posting.
Disclaimer
This update has been prepared by Sheppard, Mullin, Richter & Hampton LLP for informational purposes only and does not constitute advertising, a solicitation, or legal advice, is not promised or guaranteed to be correct or complete and may or may not reflect the most current legal developments. Sheppard, Mullin, Richter & Hampton LLP expressly disclaims all liability in respect to actions taken or not taken based on the contents of this update.
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