SEC Releases Proposed Rules on Crowdfunding
In response to a 2012 Congressional mandate, and months overdue, on October 23, the U.S. Securities and Exchange Commission (SEC) released proposed rules that would allow small businesses to raise money and sell shares over the internet using a so-called crowdfunding exchange. The proposed rules are out for a 90-day comment period, and if the SEC adopts final rules as proposed, the rules would allow smaller companies to bypass many of the restrictions that govern the sale of securities to individuals in an effort to facilitate their ability to raise small quantities of needed capital.
To date, existing securities regulations have prevented crowdfunding from being used to provide a share in any financial returns or profits of an enterprise as such revenue sharing would trigger the registration requirements governing the offer or sale of securities under the Securities Act of 1933 (Securities Act). Furthermore, under the Securities Act, a third party that operates a website to effect the purchase and sale of securities for others would be required to register with the SEC as a broker-dealer and to comply with those governing laws and regulations – a burdensome requirement for companies when small amounts of capital are being raised.
In response to these constraints, in April 2012 Congress passed the Jumpstart Our Business Startups Act (the JOBS Act), which added new Securities Act Section 4(a)(6), providing an exemption from the registration requirements of the Securities Act for certain crowdfunding transactions. The JOBS Act also laid the groundwork for internet-based platforms to facilitate the offer and sale of securities without having to register with the SEC as brokers. However, the SEC needs to adopt regulations to implement the JOBS Act.
The proposed rules provide an exemption from registration for crowdfunding, which would allow small businesses to raise money from unaccredited investors within certain parameters. 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. However, the proposed rules cap the amount of money a company could raise from any individual investor. The individual investor cap provides that over the course of a 12-month period, an investor would be permitted to invest up to:
- $2,000 or 5% of annual income or net worth, whichever is greater, if both annual income and net worth are less than $100,000; or
- 10% of annual income or net worth, whichever is greater, if either annual income or net worth is equal to or more than $100,000.
Furthermore, during the 12-month period, investors making crowdfunding investments would not be able to purchase more than $100,000 of securities through crowdfunding.
As part of the investor protections under the JOBS Act, companies availing themselves of the crowdfunding exemption would be required to raise money through an SEC-registered intermediary, either a broker-dealer or through a new type of SEC registrant known as a "funding portal." However, the proposed rules largely exempt funding portals from having to register as brokers or dealers pursuant to Securities Exchange Act of 1934 Section 15(a)(1). The Financial Industry Regulatory Authority (FINRA), which released its own set of proposed "Funding Portal Rules" concurrent with the SEC's release of the proposed rules, will monitor the funding portals.
The SEC's proposed rules would require intermediaries to: provide investors with educational materials; take measures to reduce the risk of fraud; and generally facilitate the offer and sale of crowdfunded securities. As added protection for investors, the JOBS Act and proposed rules prohibit funding portals from offering investment advice or recommendations, soliciting transactions for securities displayed on their websites, compensating employees for securities solicitations, and holding investor funds or securities.
In order to reduce the burdens on companies, the proposed rules do not mandate that issuing companies or funding portals take steps to verify the income levels and net worth of investors. However, the issuing companies would not be entirely free from oversight. The proposed rules would require companies conducting a crowdfunding offering to file certain information with the SEC, as well as to provide this information to the intermediary and investors. Required disclosure would include:
- a description of the company's business and the use of the proceeds from the offering;
- the price to the public of the securities being offered;
- information about the company's officers and directors; and
- the financial condition of the company.
Notably, the proposed rules provide for tiered financial disclosure, based on aggregate target offering amounts within the preceding 12-month period. Issuers offering $100,000 or less would be required to file (and provide to investors, potential investors, and the relevant intermediary) their tax returns for the most recently completed year (if any) and certified financial statements with the SEC. Issuers offering more than $100,000, but not more than $500,000, would be required to file with the SEC financial statements reviewed by a public accountant that is independent of the issuer. Finally, issuers offering more than $500,000 would be required to file audited financial statements with the SEC. Given that most smaller companies, due to costs, do not obtain audits of their financial statements, if this rule is finalized as proposed, it may turn out that most companies using the crowdfunding exemption do not seek to raise more than $500,000 in a 12-month period.
In addition, companies relying on the crowdfunding exemption to offer and sell securities would be required to file an annual report with the SEC and provide it to investors. As mandated by the JOBS Act and the proposed rule, securities purchased in a crowdfunding transaction cannot be resold for a period of one year. Furthermore, 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 Exchange Act.
Finally, not all companies will be eligible to use the crowdfunding exemption. Companies that are not domiciled in the U.S., already are SEC reporting, have no specific business plan, or those that have indicated their business plan is to merge with or acquire an unidentified company will not be eligible.
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