November 11, 2013
On October 23, 2013, the Securities and Exchange Commission (the SEC or the Commission) approved the release of proposed “crowdfunding” rules implementing Title III of the 2012 Jumpstart Our Business Startups Act (the JOBS Act). Title III of the JOBS Act created an exemption, under Section 4(a)(6) of the Securities Act of 1933, as amended (the Securities Act), from registration for securities issued in crowdfunding transactions. The comment period for the proposed rules will end February 3, 2014.
Once the SEC adopts final implementing rules, the crowdfunding exemption will allow U.S. private companies (primarily startups and small businesses) to raise up to $1 million in any continuous 12-month period from an unlimited number of investors without regard to their sophistication and without registration under the Securities Act. Those engaging in such fundraising activities will be required to conduct these offerings through a registered intermediary–either a registered broker or an online “funding portal.” Until the SEC adopts final rules, however, issuers will not be able to rely on the crowdfunding exemption.
The extent to which issuers utilize the crowdfunding exemption is likely to be driven largely by issuers’ determination as to whether the exemption’s benefits outweigh its limitations, requirements, and potential liabilities, including costs and burdens arising from the statutory liability of intermediaries, which is similar to that of underwriters in a registered offering. In addition, the success of the exemption will depend in part on whether potential investors in these offerings are willing to make investments that may carry high risk in securities for which there will likely be severely limited liquidity. We discuss below how certain provisions contained in Section 4(a)(6) and in the proposed rules may affect this analysis.
Limitations on Offering Size and Investment Amount
Section 4(a)(6) provides that an issuer may issue up to $1 million (including any securities issued by any predecessor issuer or any issuer controlled by or under common control with the issuer) in a continuous 12-month period in offerings pursuant to the crowdfunding exemption. Under the proposed rules, amounts raised in another type of exempt offering would not count against the $1 million cap. In addition, an exempt crowdfunding offering would generally not be integrated with an offering pursuant to another exemption, so long as all of the conditions of each exemption are satisfied. For instance, if the issuer were to engage in general solicitation in an offering pursuant to Rule 506(c) under Regulation D, the issuer would need to satisfy itself that the general solicitation did not constitute impermissible advertising of the crowdfunding offering; likewise, in an offering pursuant to Rule 506(b) under Regulation D, the issuer would need to satisfy itself that any notices regarding the crowdfunding offering and the posting of the crowdfunding offering on the intermediary’s platform did not constitute general solicitation with respect to the Rule 506(b) offering. Similarly, the amount that an issuer could raise under the crowdfunding exemption would not be affected by the amount of any non-securities crowdfunding (fundraising in which contributors receive something of value related to the project, such as listing donors in the credits of a film funded by such contributions, or where the amount contributed constitutes the pre-purchase of a product) by the issuer.
The Commission noted that taking a more restrictive approach to these issues “would be inconsistent with the goal of alleviating the funding gap faced by startups and small businesses because it would place a cap on the amount of capital startups and small business could raise.” Thus, while the statutory cap on crowdfunding offerings may limit the utility of the exemption for issuers with more extensive financing needs, the proposed rules ensure that these businesses will not need to choose between engaging in crowdfunding offerings and availing themselves of other fundraising options.
Separate from the limitation on the amount an issuer can raise through crowdfunding, Section 4(a)(6) also limits the amount that any investor can invest in crowdfunding offerings over a continuous 12-month period, based on an investor’s annual income and net worth. The maximum aggregate investments in any 12-month period under the proposed rules are as follows:
Notably, these limitations reflect a permissive interpretation of the relevant provisions of the JOBS Act. The Commission has requested comment on whether the final rules should take a more restrictive reading.
Recognizing that “it would be difficult for intermediaries to monitor or independently verify whether each investor remains within his or her investment limits for each particular offering in which he or she intends to participate,” the Commission declined to propose a high standard on issuers and intermediaries for determining the amount that an investor would be permitted to invest in any crowdfunding offering. Thus, an intermediary “may rely on an investor’s representations concerning compliance with investment limitation requirements based on the investor’s annual income and net worth and the amount of the investor’s other investments” in crowdfunding offerings. An intermediary, and the issuer, will be permitted to rely on such representations so long as they do not have “reason to question the reliability of the representation.” For example, the intermediary likely would not be reasonable if it were to disregard the amount of other investments that the investor has made through an account with that intermediary, if such investments collectively exceed the investor’s maximum annual investment amount.
Limits on Advertising
Under the proposed rules, issuers would be permitted to post advertisements containing minimal information about their offering–similar to a “tombstone” advertisement in connection with a registered offering. The proposed rules would permit an advertisement to include only:
Although it is likely that these fairly stringent limitations on advertising will reduce the impact of the crowdfunding exemption on the capital raising activities of small, very early-stage businesses, the Commission has very little discretion to permit broader advertising in light of the statutory mandate that issuers not advertise the terms of the offering except for notices directing investors to the intermediary.
Issuer Disclosures and On-going Reporting
Section 4(a)(6) and the proposed rules would require that issuers file with the Commission, and make available to the intermediary and to investors, certain disclosures, including financial information about the issuer for the prior two fiscal years (or for such shorter time as the issuer has been in existence), as well as certain information similar to what is required to be disclosed in a registration statement for a public offering. The financial information required of the issuer would depend on the aggregate amount of securities offered in crowdfunding transactions, as measured on a rolling 12-month basis, and would include:
In each case, the financial statements would be required to be prepared in accordance with U.S. GAAP.
The proposed rules would implement specific disclosure requirements contained in the statutory provisions, and would impose other disclosure requirements pursuant to the Commission’s discretionary authority to require disclosures in the public interest and for the protection of investors.
The proposed rules to implement disclosures mandated by the statute are generally somewhat narrower in scope, or grant the issuer greater flexibility in determining what to disclose, than comparable disclosure requirements for registered offerings. For example, with respect to the description of the issuer’s business, the Commission noted that “issuers engaging in crowdfunding transactions may have businesses at various stages of development in differing industries, and therefore, we believe that the proposed rules should provide flexibility for issuers to discuss the information about their businesses” rather than prescribing specific disclosure requirements. Similarly, disclosure of the business experience of directors and officers of the issuer would be limited to three (rather than five) years.
At the same time, the Commission interpreted some of the statutorily mandated disclosures more broadly than the statute necessarily requires, and added disclosure requirements not mandated by the statute. For example, the statute requires that issuers describe their ownership and capital structure, but the proposed rules would require disclosure of the number of securities being offered and/or outstanding, whether or not such securities have voting rights, and any limitations on such voting rights. While the statute requires that issuers describe their financial condition, under the proposed rules, issuers would be expected to discuss their financial condition “in a manner similar to” the management’s discussion and analysis of financial condition and results of operations (MD&A) required by Item 303 of Regulation S-K. While the proposed rules do not prescribe the content or format for this information and the Commission states that it “expect[s] that the discussion would not generally need to be as lengthy or detailed” as the MD&A of companies reporting under the Securities Exchange Act of 1934, as amended (the Exchange Act), this level of disclosure is arguably greater than that required by the statute.
In addition, the proposed rules would require disclosures that were not mandated by the statute, including, among others:
While all of these disclosures may be advisable for the protection of investors, they meaningfully increase the disclosure burden on crowdfunding issuers.
The net result of the proposed disclosure requirements is that issuers will be required to provide disclosure that is similar in nature, though narrower in scope, to the disclosures that would be required in a registered offering. The Commission noted that “[c]ommenters expressed concerns [in advance of its proposal] about the extent of the disclosure requirements and stated that overly burdensome rules would make offers and sales [under the crowdfunding exemption] prohibitively expensive.” The proposing release stated that the Commission had “considered [these comments] in determining the disclosure requirements that [it] should propose.” Ultimately, the attractiveness to an issuer of engaging in a crowdfunding offering will likely depend in large part on the appetite of the issuer to draft the required disclosures.
In addition to the disclosure requirements in connection with a crowdfunding offering, issuers will be required to file an annual report containing information about the issuer and its financial condition similar to that required in their offering document, but excluding information about the offering itself. In order to improve compliance with the on-going reporting requirement, an issuer would not be permitted to engage in subsequent crowdfunding transactions unless it is current in its on-going disclosure obligations.
New Section 4A(e) of the Securities Act provides that securities issued in reliance on the crowdfunding exemption may not be transferred for a period of one year following the date of purchase, except: (1) to the issuer; (2) as part of a registered offering; (3) to an accredited investor as defined under Rule 501(a) of Regulation D; or (4) to a family member (as defined in accordance with SEC rules), or to a trust controlled by an initial purchaser or for the benefit of a family member, or in connection with the death or divorce of the purchaser or other similar circumstances.
These transfer restrictions will have the effect of limiting the development of secondary markets in crowdfunded securities. To address this limitation, third-party vendors and platforms may begin to provide accredited investor status verification services to expand the opportunities for investors in crowdfunded securities to resell such securities. Initial appetite for crowdfunded securities may temper, however, once less sophisticated investors understand that their investments cannot be freely resold. This concern may be heightened if the Commission adopts additional limitations on resale after the first year, or if resale or trading is restricted when the issuer is no longer in compliance with on-going reporting requirements or is out of business, as suggested by the Staff’s questions in the proposing release.
Issuer and Intermediary Liability
Issuers and intermediaries in crowdfunding transactions are subject to liability under federal securities laws similar to registered offerings. First, the antifraud and civil liability provisions of Securities Act Sections 12(a)(2) and 17 apply to crowdfunding transactions, as do the antifraud provisions of Section 10(b) and Rule 10b-5 under the Exchange Act. Second, new Section 4A(c) of the Securities Act provides for liability if the issuer (which is defined to include its directors and key executive officers and other persons who offer the securities), in the offer or sale of the securities, “makes an untrue statement of a material fact or omits to state a material fact required to be stated or necessary in order to make the statements, in light of the circumstances under which they were made, not misleading, provided that the purchaser did not know of the untruth or omission.” The issuer will have a defense against liability under Section 4A(c) if it establishes that it “did not know, and in the exercise of reasonable care could not have known, of the untruth or omission.” This liability standard and defense are similar to Section 12(a)(2) of the Securities Act.
If an investor brings a successful action pursuant to Section 4A(c), it may be entitled to recover the amount of consideration paid for the applicable security with interest, or damages if the investor no longer holds the security. In accordance with Sections 12(b) and 13 of the Securities Act, damages are limited to loss of value of the security resulting from material untruths or omissions if suit is brought within one year after discovery of the offending statement (or after discovery should have been made by reasonable diligence), or three years after sale of the security, as applicable. Notably, because there will likely be a limited secondary market for securities issued in crowdfunding offerings and therefore scant price data, it may be difficult to prove the amount of the loss of value.
The proposing release also notes that, under Section 4A(c)(3), funding portals and registered brokers serving as crowdfunding intermediaries are likely subject to the same potential liability as issuers, subject to a “due diligence” defense if the intermediary establishes that it did not know and in the exercise of “reasonable care” could not have known of a material misstatement or omission when offering crowdfunded securities. The proposing release suggests certain steps that intermediaries could take to exercise “reasonable care,” including implementing policies and procedures designed to ensure compliance with the regulations governing crowdfunding, and review of the issuer’s offering documents to identify potentially materially false or misleading information.
Market practice and further Staff guidance will suggest the ultimate extent of this due diligence burden, and numerous questions remain unresolved. Will required due diligence be greater than that already applicable to registered brokers offering exempt securities under Regulation D? Will crowdfunding intermediaries be prepared to spend additional time and expense on due diligence, and will issuers be prepared to compensate intermediaries for such efforts? Will intermediaries retain outside advisors, including counsel, to assist them? The answers to these and other questions may influence the feasibility of acting as a crowdfunding intermediary, and market practices over time will reveal whether the crowdfunding statutory liability regime will temper issuance activity by issuers and intermediaries.
The statutory framework for crowdfunding includes a number of explicit provisions and rulemaking mandates intended to protect crowdfunding investors that could ultimately dampen interest in such offerings. In addition, the SEC’s proposed rules interpreted some of its statutory mandates, and included certain other provisions pursuant to its discretionary authority, in ways that may also reduce issuers’ and intermediaries’ interest in these offerings. These protections may ultimately be necessary, however, to establish an offering regime that investors trust will provide them with the protections that they require to enter this market. The input received from commenters on the proposed rules should have a significant influence on the rules that the SEC ultimately adopts, and it will likely take some time after adoption of any final rules before the market will judge the success of the crowdfunding exemption.
 Crowdfunding, Release No. 33-9470 (Oct. 5, 2013) [78 FR 66427] (available at: http://www.sec.gov/rules/proposed/2013/33-9470.pdf).
 Although the term “crowdfunding” is often used generally to refer to securities offerings conducted online, including online offerings involving the use of general solicitation pursuant to Rule 506(c) of Regulation D under the Securities Act, we use “crowdfunding” herein to refer only to offerings pursuant to the specific crowdfunding exemption provided by Section 4(a)(6).
 Crowdfunding intermediaries will be subject to Section 4A(a) of the Securities Act, and the proposing release includes proposed rules to implement these requirements. Under Section 4A(a) and the proposed rules, intermediaries would be required to provide investors with educational materials and information regarding the issuer and its offering, including risks associated with crowdfunding investments. Intermediaries would also be required to take certain steps to reduce the risk of fraud and provide communication channels to permit discussions regarding an offering. Officers, directors and partners of an intermediary would be prohibited from having any financial stake in any crowdfunding issuer using its services. The proposed rules also provide for disqualification of intermediaries in certain circumstances under conditions that are somewhat broader than Rule 262 of Regulation A under the Securities Act.
 Funding portals may act solely as intermediaries and may not otherwise handle customer funds, offer investment advice or recommendations, solicit investments or compensate employees, agents or other persons to do so. Funding portals would be required to register as such with the SEC on Form Funding Portal, and would also be required to register with FINRA. On October 24, 2013, FINRA proposed funding portal rules and related forms. See Jumpstart Our Business Startups (JOBS) Act, FINRA Requests Comment on Proposed Funding Portal Rules and Related Forms, FINRA Regulatory Notice 13-34 (Oct. 24, 2013) (available at:
 A natural person’s net worth would be calculated in accordance with the SEC’s accredited investor rules, which exclude the value of the person’s primary residence.
 The Commission requested comment on whether, if either the investor’s annual income or net worth is less than $100,000, the investment limitation should be calculated at the 5% threshold rather than the 10% threshold. The Commission also requested comment on whether, at either the 5% or the 10% threshold, an investor’s annual investment should be calculated based on the lesser, rather than the greater, of the investor’s annual income or net worth.
 However, Section 11 of the Securities Act, which provides for registration statement liability, would not apply to crowdfunding transactions under Section 4(a)(6).
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