Crowdfunding: Securities and Exchange Commission Adopts Final Rules
Four years after its enactment on April 5, 2012, the JOBS Act will take effect with the Securities and Exchange Commission’s (“SEC”) adoption of final rules governing crowdfunding.[2] “Crowdfunding” refers to the raising of funding necessary for a project or venture through soliciting small amounts of money from a large number of people, most typically through promotions over the Internet.[3] In this regard, unlike capital campaigns focused on traditional investors, crowdfunded projects rely on contributions from the general public.[4] Prior to the enactment of Title III of the Jumpstart Our Business Startups Act (“JOBS Act” or the “Act”), crowdfunding did not allow for the sale of equity in the company.[5] Individuals who funded the projects received various rewards, often the very product they were backing, but at a reduced price.[6] Although companies could choose to sell equity shares, such sales would be subject to the registration requirements of the Securities Act of 1933.
Congress passed the JOBS Act for the purpose of improving job creation and spurring economic growth.[7] A cornerstone provision of the Act was Title III, Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act of 2012 (“CROWDFUND Act”).[8] The CROWDFUND Act created an exemption to the registration requirements for issuing equity securities under the Securities Act of 1933.[9] The reasoning behind the exemption was to relieve small businesses and startup companies from the costly and burdensome requirements associated with the issuance of security interests under the existing Securities Act.[10] However, companies wishing to use the exemption to raise capital through the Internet via the CROWDFUND Act still must comply with the requirements of the exemption, which includes the disclosure of information about the company to potential investors.[11] The concept of crowdfunding security interests as a form of capital financing for businesses arose out of the already ubiquitous practice of crowdsourcing.[12] Crowdsourcing utilizes the power of the Internet to reach out to the public at large and solicit small amounts of funding from many investors in order to raise enough capital to commence a project.[13] These projects have included activities such as creating t-shirts, new designs for a smartphone case, or a new musical album, mostly within the creative arts realm.[14] Crowdfunding extends this solicitation of small amounts of funding to the raising of equity.
On October 23, 2013, the SEC released a set of proposed rules for the CROWDFUND Act and requested that the public submit comments.[15] This release offered the first opportunity to examine the SEC’s thoughts on regulating disclosure under the exemption and the additional requirements to be imposed on businesses intending to raise capital through the sale of equity via the Internet.[16] After a nearly two year period, the SEC issued a public release on October 30, 2015 indicating adoption of a set of final rules for the CROWDFUND Act.[17] These rules, and accompanying forms, go into effect on May 16, 2016.[18] The rules apply primarily to three groups affected by the offering of securities under the Act; investors, small businesses and startups selling equity, and intermediaries.[19]
Regulating Individual Investors
A main concern with offering investors an opportunity to purchase small amounts of equity in companies through the Internet was the sophistication, or lack thereof, of the investors and their potential exposure to risk and fraud. The final rules adopted by the SEC mitigate this risk by limiting the amount of investment any one individual can make as well as the total amount of funding a company may seek. An individual investor’s total investment over a 12-month period is limited to the greater of $2,000 or 5 percent of the lesser of their annual income or net worth, if either their annual income or net worth is less than $100,000.[20] However, if both the investor’s annual income and net worth are greater than $100,000, the investor is limited to a total investment over the 12-month period of 10 percent of the lesser of their annual income or net worth.[21] Regardless of their income and net worth, the total investment in securities offered under the CROWDFUND exemption by an individual during the entire 12-month period may not exceed $100,000.[22] The company seeking equity funding under the Act is also limited during each 12-month period to raising a maximum of $1 million in capital through their crowdfunded offerings.[23] Generally, securities purchased under the crowdfunding exemption may not be resold for one year.[24]
Regulating Companies Under the Exemption
Companies choosing to take advantage of the exemption under the Act are still subject to certain disclosure requirements, though not as rigorous or extensive as those for registered offerings under the Securities Act. Examples of the information a company is required to disclose under the SEC rules include:[25]
- The public price of the securities or the method to be used to determine the price, the target amount of investment sought, and whether the company will accept a greater investment than the target offering;
- The company’s financial position;
- A financial statement accompanied by the appropriate level of review;
- A description of the business and the intended use of the proceeds of the equity offering; and
- Information about the officers and directors and any owners possessing twenty percent or more of the company.
The independent review required of the financial statements issued by the company is tiered, and corresponds with the amount of capital to be raised.[26] Companies with an offering of $100,000 or less simply need to be certified an executive officer, unless statements are available that have been audited or reviewed by a public accountant.[27] If the amount of capital to be raised through the offering is between $100,000 and $500,000, the company must provide financial statements that have been reviewed by an independent accountant, unless there are statements that have already been audited by an independent accountant.[28] Finally, companies seeking between $500,000 and $1 million in capital must also provide financial statements that have been reviewed by an independent accountant, unless there are statements that have already been audited by an independent accountant or the company has previously sold securities under the crowdfunding regulation, in which case the audited financial statements must be disclosed.[29] Companies relying on the crowdfunding exemption will also need to file an annual report with the commission and provide the report to its investors.[30] Certain companies, however, are not eligible to utilize the exemption provided by the CROWDFUND Act, including those that fail to comply with the annual reporting requirements under the regulation.[31]
Regulation of Funding Platforms
In addition to regulating investors and the companies offering securities via the exemption, the CROWDFUND Act also regulates platforms for crowdfunding (intermediaries and funding portals). A crowdfunding transaction must take place through an intermediary, either a broker or the newly created funding portal.[32] A funding portal as defined under the Act and rules refers to a broker, or any person, acting as an intermediary—selling or offering securities on the account of another.[33] An intermediary “means a broker registered under section 15(b) of the Exchange Act (15 U.S.C. 78o(b)) or a funding portal registered under § 227.400 and includes, where relevant, an associated person of the registered broker or registered funding portal.”[34] Intermediaries, including funding portals, must register with the SEC and become members of a national securities association such as the Financial Industry Regulatory Authority Inc. (FINRA).[35] Intermediaries are required to provide educational materials to investors explaining their investment process, identifying the types of securities offered, and the information required to be disclosed by the company seeking capital. Additional requirements of companies facilitating the sale of equity securities through the CROWDFUND Act include:[36]
- Taking measures to reduce the risk of fraud;
- Providing the capability for discussions about offerings on the platform;
- Informing investors of the compensation received by the intermediary; and
- Having a reasonable basis for believing that an investor complies with the investment limitations.
A funding portal is prohibited from having a financial interest in any company for whom it is selling securities, except as compensation for its services, and from paying for personally identifiable information of an investor or potential investor. Funding portals are also prohibited from offering investment advice, soliciting purchases, and compensating promoters.[37] The rules do include a non-exclusive safe harbor that allows funding portals to take certain limited actions within the confines of the restrictions.[38]
Liability for issuers and intermediaries under the CROWDFUND Act arises through Section 4A(c) of the Securities Act.[39] Issuers of securities through a transaction under the CROWDFUND Act are liable to purchasers for any untrue statement of a material fact or the omission of a material fact in connection with either the offer or sale of the security, provided the purchaser did not know of the untruth or omitted fact. Investors are not precluded under the Act from bringing a private right of action against a funding portal, and issuer liability would be specific to the facts and circumstances of the particular incident.[40]
Conclusion
The passage of the CROWDFUND Act and the adoption of rules by the SEC provide a new mechanism allowing small businesses and startups the opportunity to raise capital through offering equity securities to a multitude of investors through the Internet. Whether this exemption allows for cheaper, easier capital funding opportunities for these small companies remains to be seen. More information about the Act and the rules adopted by the SEC can be found online at the SEC’s website, http://www.sec.gov.
[1] Mr. Smith is currently a law clerk for the Court of Appeals of Maryland. The opinions, positions, statements, and/or views expressed in this article are solely those of the author, and do not reflect those of the Maryland Judiciary.
[2] 17 C.F.R. § 227.100 et seq. (May, 16, 2016).
[3] Tanya Prive, What Is Crowdfunding And How Does It Benefit The Economy, www.forbes.com, Nov. 27, 2012, http://www.forbes.com/sites/tanyaprive/2012/11/27/ what-is-crowdfunding-and-how-does-it-benefit-the-economy/#13366acc4ed4.
[4] Id.
[5] Ryan Fiet, Equity Crowdfunding by the Numbers, www.inc.com, Nov. 16, 2015, http://www.inc.com/ryan-feit/equity-crowdfunding-by-the-numbers.html.
[6] Id.
[7] Jumpstart Our Business Startups Act, Pub. L. No. 112-106 §§ 301-305 (2012) [hereinafter JOBS Act] (codified at 15 U.S.C.). The JOBS Act, in part, intended to make investment capital available to small businesses and start-up companies unable to obtain financing through existing channels.
[8] Id. § 301 at 315.
[9] Id. § 302 at 315-16; Securities Act of 1933, 15 U.S.C.A. § 77a (West 2012).
[10] 15 U.S.C.A § 77a (West 2012). See also 15 U.S.C.A. § 77f (West 2012) (describing the registration of securities).
[11] 15 U.S.C.A. § 77d(a)(6)(D) (West 2012). Section 77d(a)(6)(D) requires companies issuing securities under the crowdfunding exemption comply with the disclosure requirements contained in section 77d-1(b). Id.
[12] Joan MacLeod Heminway & Sheldon Ryan Hoffman, Proceed at Your Peril: Crowdfunding and the Securities Act of 1933, 78 Tenn. L. Rev. 879, 881 (2011) (quoting Paul Belleflamme et al., Crowdfunding: Tapping the Right Crowd 2 (Feb. 21, 2011) (unpublished manuscript), available at http://ssrn.com/abstract=1578175); Andrew A. Schwartz, Crowdfunding Securities, Notre Dame L. Rev. 1457, 1459 (2013).
[13] Ajay K. Agrawal, Et Al., Some Simple Economics of Crowdfunding 3 (NBER, Working Paper No. 19133, 2013); see also Ethan Mollick, The Dynamics of Crowdfunding: An Exploratory Study, Journal of Business Venturing 3 (2013), http://dx.doi.org/10.1016/j.jbusvent.2013.06.005(discussing the “Pebble” smart watch project).
[14] Schwartz, supra note 7 at 1458.
[15] SEC proposed rules (2013), http://www.sec.gov/rules/proposed/2013/33-9470.pdf; see also Security and Exchange Commission, SEC Issues Proposal on Crowdfunding, U.S. Securities and Exchange Commission, http://www.sec.gov/News/PressRelease/Detail/PressRelease/1370540017677#.UtA4G2R4aBU.
[16] Until the release of the proposed rules by the SEC, commentary on the likely effects of the CROWDFUND Act was based on speculation and came with the caveat that until the SEC acted no one could be sure of how burdensome the disclosure requirements might be on small businesses and startups. Supra note 7. See also Stuart Evan Smith, The Securities and Exchange Commission’s Proposed Regulations Under the Crowdfund Act Strike A Necessary Balance Between the Burden of Disclosure Placed on Issuers of Securities and Meaningful Protection for Unsophisticated Investors, 44 U. Balt. L. Rev. 127 (2014).
[17] SEC final rules (2015) [hereinafter Final Rules], http://www.sec.gov/rules/final/2015/33-9974.pdf; see also Security and Exchange Commission, SEC Adopts Rules to permit Crowdfunding, U.S. Securities and Exchange Commission, http://www.sec.gov/news/pressrelease/2015-249.html.
[18] One exception to the May 16, 2016 effective date for the rules and forms is that instruction 3, adding part 227 and instruction 14, amending form ID, became effective on January 29, 2016.
[19] One notable addition to the landscape of securities under the CROWDFUND Act is the creation, or designation, of intermediaries, or funding portals, to facilitate the offerings made by companies using the exemption for crowdfunding.
[20] 17 C.F.R. § 227.100(a)(2) (May 16, 2016). See also Final Rules at 547-48.
[21] Id.
[22] Id.
[23] 17 C.F.R. § 227.100(a)(1) (May 16, 2016). See also Final Rules at 547.
[24] 17 C.F.R. § 227.501(a) (May 16, 2016). See also Final Rules at 594-95.
[25] See 17 C.F.R. § 227.201 (May 16, 2016) for a full listing of required disclosures. See also Final Rules at 550-62.
[26] 17 C.F.R. § 227.201(t) (May 16, 2016). See also Final Rules at 557-58.
[27] 17 C.F.R. § 227.201(t)(1) (May 16, 2016). See also Final Rules at 557.
[28] 17 C.F.R. § 227.201(t)(2) (May 16, 2016). See also Final Rules at 557.
[29] 17 C.F.R. § 227.201(t)(3) (May 16, 2016). See also Final Rules at 558.
[30] 17 C.F.R. § 227.202 (May 16, 2016). See also Final Rules at 562-64.
[31] Companies unable to take advantage of raising capital by selling equity through crowdfunding include non-U.S. companies, Exchange Act reporting companies, companies subject to disqualification under Regulation Crowdfunding, and companies with no specific business plan. 17 C.F.R. § 227.100(b) (May 16, 2016). See also Final Rules at 549-50.
[32] Securities Act § 4(a)(6)(C).
[33] 17 C.F.R. § 227.302(c)(2) (May 16, 2016).
[34] 17 C.F.R. § 227.302(c)(3) (May 16, 2016).
[35] 17 C.F.R. § 227.400(a) (May 16, 2016).
[36] 17 C.F.R. § 227.300 et seq. (May 16, 2016). See also Final Rules at 568-81.
[37] A full listing of the prohibited activities is contained in 17 C.F.R. § 227.300(c)(2) (May 16, 2016). See also Final Rules at 570.
[38] 17 C.F.R. § 227.402 (May 16, 2016). See also Final Rules at 586-90. Additional permitted actions include, but are not limited to, the use of objective criteria (e.g. geography) to highlight offerings, creation of search tools to navigate the offerings, providing compensation to third parties for referring persons to the portal, and advertising the existence of the portal.
[39] Securities Act § 4A(c); 15 U.S.C.A § 77d-1(c) (West 2012).
[40] Final Rules at 333-37.