SEC Proposes Crowdfunding Rules | Practical Law

SEC Proposes Crowdfunding Rules | Practical Law

The SEC has proposed rules and forms that would implement Title III of the JOBS Act, the crowdfunding provision.

SEC Proposes Crowdfunding Rules

Practical Law Legal Update 1-546-8105 (Approx. 10 pages)

SEC Proposes Crowdfunding Rules

by Practical Law Corporate & Securities
Published on 24 Oct 2013 • USA (National/Federal)
The SEC has proposed rules and forms that would implement Title III of the JOBS Act, the crowdfunding provision.
On October 23, 2013, the SEC issued proposed rules and forms that would implement Title III of the JOBS Act, the crowdfunding provision. Title III created an exemption from registration under the Securities Act for certain "crowdfunding" securities offerings conducted through "crowdfunding intermediaries" that meet certain conditions, and are offered to a large number of investors (including non-accredited investors), each of whom invests a relatively small amount. The exemption is not available until the SEC adopts implementing rules.
The proposed crowdfunding rules and forms, which, if adopted, would implement the crowdfunding exemption, include:
  • Regulation Crowdfunding, a new regulation that would:
    • govern offerings made in reliance on the Section 4(a)(6) exemption from Securities Act registration;
    • provide a framework for the operations of crowdfunding intermediaries, including funding portals and brokers, and create a registration regime for funding portals;
    • place restrictions on the resale of securities sold in Section 4(a)(6) offerings; and
    • exempt securities sold in Section 4(a)(6) offerings from counting toward the Securities Exchange Act Section 12(g) registration threshold.
  • Form C, a new form that issuers in Section 4(a)(6) offerings would be required to file:
    • before the commencement of a Section 4(a)(6) offering;
    • during the pendency of a crowdfunding offering to report progress toward the funding goal and, when applicable, certain changes to the offering or updates;
    • annually after completing a crowdfunding offering; and
    • at the conclusion of their Form C reporting obligations.
  • Form Funding Portal, a new form that funding portals (permitted crowdfunding intermediaries other than registered brokers) would file to register with the SEC, to update information and to terminate their registration.
On the same day, FINRA issued a regulatory notice soliciting comments on proposed rules and forms that would govern SEC-registered crowdfunding portals (see Legal Update, FINRA Issues Crowdfunding Portal Regulatory Notice and Proposed Rules).
The term "crowdfunding" is used colloquially to refer to several fundraising techniques, including some techniques that do not count as offers and sales of securities under federal law, as well as some techniques that are securities offerings but rely on exemptions from Securities Act registration other than Section 4(a)(6) (for more information, see Article, Crowdfunding Right Now: Alternatives to Title III of the JOBS Act and Practice Note, JOBS Act: Regulation D and Rule 144A General Solicitation Summary: Exemption from Broker-Dealer Registration). In this Legal Update, the terms "crowdfunding" and "crowdfunding offering" are used solely to refer to securities offerings made in reliance on Section 4(a)(6).

Section 4(a)(6) Exemption from Securities Act Registration

Regulation Crowdfunding implements and further clarifies the statutory requirements of the Section 4(a)(6) exemption for crowdfunding offerings and in some instances imposes conditions beyond those required by the JOBS Act.

Disclosure and Financial Statement Requirements

Section 4A(b)(1) of the Securities Act requires issuers relying on the Section 4(a)(6) exemption to conduct a crowdfunding offering to file certain information with the SEC, and to provide it to investors, potential investors and the crowdfunding intermediary for the offering (for more information on the statutory requirements, see Practice Note, JOBS Act: Crowdfunding Summary: Disclosure and Other Requirements for Crowdfunding Issuers). Section 4A(b)(1)(I) of the Securities Act gives the SEC authority to require additional disclosure.
Under the proposal, a crowdfunding issuer would be required to prepare and file a Form C on EDGAR before the commencement of the offering. Among other things, Form C would need to include information on:
  • The issuer itself, including name, address and entity form.
  • The issuer's directors and officers, including their history with the company, business experience for the past three years and other information.
  • The issuer's 20% or greater beneficial equityholders.
  • The issuer's business and business plan. The proposal does not prescribe the details of this requirement, but the proposing release asks for comment on whether it should do so, including by providing a non-exclusive list of required information or requiring line-item responses.
  • The use of proceeds.
  • The target offering amount and deadline to reach it. Issuers would also be required to describe how investors may cancel an investment commitment and include statements that:
    • commitments may be cancelled until 48 hours before the deadline;
    • if a material change to the offering occurs, investors must reconfirm their commitment or it will be cancelled and funds returned; and
    • if the target offering amount is not met, commitments will be cancelled and funds returned.
  • The offering price and how it will be determined.
  • The issuer's ownership and capital structure, including information about the terms (such as voting rights and transfer restrictions) of the securities being offered and other outstanding securities. Other information, including about the risks of being a minority owner, would be required.
  • The following matters (these disclosure requirements are not directly required by statute):
    • the intermediary for the offering and compensation being paid to the intermediary;
    • number of current employees of the issuer;
    • risk factors;
    • material terms of the issuer's indebtedness;
    • exempt offerings of the issuer in the last three years; and
    • certain related party transactions.
The proposal would require an issuer to provide the following financial information, depending on the aggregate amount the issuer offers and sells under Section 4(a)(6) in a rolling 12-month period:
  • Offerings of $100,000 or less. US GAAP financial statements for the two most recently completed fiscal years or shorter period during which the issuer has been operating, and filed income tax return for the most recently completed fiscal year, if any, in both cases certified true and complete by the issuer's principal executive officer. Grace periods are provided, and certain personal information may be redacted.
  • Offerings of between $100,000 and $500,000. US GAAP financial statements reviewed (in accordance with AICPA standards) by a public accountant independent of the issuer under Rule 2-01 of Regulation S-X, and accompanied by the accountant's review report.
  • Offerings over $500,000. US GAAP financial statements audited (in accordance with AICPA or PCAOB standards) by an independent auditor, accompanied by the audit report.
An issuer would also be required to provide a narrative discussion of its financial condition covering, among other things, its historic results of operations and liquidity and capital resources. According to the proposing release, this discussion would be similar to MD&A, but generally not as lengthy or detailed considering the probable more limited operating history, complexity and scale of crowdfunding issuers.
A crowdfunding issuer would need to file updates to Form C (designated Form C-U) with information on the company's progress toward reaching its target offering amount. An issuer would need to amend its disclosure if a material change or update occurred (on a filing designated Form C-A).
Each Section 4(a)(6) issuer would be required to file with the SEC and post to its website an annual report within 120 days of the end of each fiscal year (on a filing designated Form C-AR). This annual report would include information similar to the offering statement on Form C, including the financial statement and narrative disclosures meeting the highest standard applicable to any of the issuer's past Section 4(a)(6) offerings, but excluding offering-specific information. The annual reporting requirement would continue until one of the following events occurred:
  • The issuer becomes a reporting company.
  • All the issuer's securities sold under Section 4(a)(6) are purchased by a third party or repurchased by the issuer.
  • The issuer liquidates or dissolves its business under state law.
The issuer would be required to file a notice of termination of its annual reporting obligation on Form C-TR.

Advertising and Communications

Under the proposal, issuers would only be permitted to advertise their offerings through a notice containing certain specific limited information (similar to "tombstone ads" under Rule 134 under the Securities Act). The notice must direct readers to the crowdfunding intermediary platform for the offering. Potential investors could then access additional information about the offering through the platform. The notice could be in print or distributed electronically, including through social media.
However, under the proposal, there would be no restriction on an issuer's ability to:
  • Communicate with investors or potential investors on the intermediary's platform, as long as the issuer identifies itself as the issuer in these communications. This allows the issuer to answer questions or challenge statements made about it during the offering process.
  • Make communications that do not refer to the terms of the offering (for example, the issuer could continue to advertise its products or services).

Limits on Capital Raised and Individual Investment

The Section 4(a)(6) exemption is limited by its terms to offerings not exceeding maximum amounts of capital raised and amounts invested. Proposed Regulation Crowdfunding is designed to help issuers and investors apply these statutory limits. The proposal clarifies:
  • Application of the $1 million per issuer, per year capital raise maximum. Under the proposal, only securities sold under Section 4(a)(6) (and not any other exemption from registration) would count toward an issuer's $1 million capital raise maximum. In calculating the limit, an issuer would be required to add together proceeds raised in Section 4(a)(6) issuances by the issuer itself, its predecessors and entities it controls or is under common control with. The amount of these issuances cannot exceed $1 million in any rolling 12-month period.
  • Investment limits. There is significant ambiguity in the statutory language limiting the amount an issuer may sell in any one year to any single investor in crowdfunding offerings. The proposal adopts an approach seeking to resolve the ambiguity. More significantly, the proposal would permit crowdfunding issuers to rely on the efforts of crowdfunding intermediaries to determine whether an investor has reached the limits (provided that the issuer does not have actual knowledge to the contrary).

Integration Mechanics

According to the proposing release, in the SEC's view, Section 4(a)(6) offerings would not be integrated with any other exempt offerings by the issuer, as long as each offering complies with its respective exemption. However, if an issuer is conducting a Section 4(a)(6) offering concurrently with an offering made in reliance on an exemption that does not permit general solicitation, the issuer would need to be satisfied that investors in the latter offering became interested in the offering through means other than general solicitation regarding the Section 4(a)(6) offering.

Public Accessibility

The proposal includes two requirements intended to ensure crowdfunding offerings permit public access to information about the offering and information sharing among the "crowd." The proposal would require that each offering be conducted using only one intermediary and all offerings be conducted on the internet.

Ineligible Companies and Bad Actor-style Disqualification

Section 4A(f) of the Securities Act makes certain categories of issuers ineligible to rely on Section 4(a)(6) (including foreign issuers, reporting companies, investment companies and companies excluded from that definition by Sections 3(b) and (c) of the Investment Company Act (including most hedge funds)).The proposal would also make the following issuers ineligible to rely on Section 4(a)(6):
  • Issuers that failed to make required Form C filings in the two years before a crowdfunding offering:
  • Issuers with no business plan or a business plan to engage in a merger with an unidentified company or companies.
Section 302(d) of the JOBS Act requires the SEC to establish a disqualification provision for crowdfunding offerings substantially similar to those of Rule 262 of Regulation A. The proposal would adopt disqualification provisions similar to Rule 506(d), which disqualifies certain issuers from relying on the Regulation D safe harbor from Securities Act registration (see Practice Note, Section 4(a)(2) and Regulation D Private Placements: Bad Actors Disqualified from Relying on Safe Harbor).
Under the proposed crowdfunding disqualification provision, an issuer will be unable to rely on the crowdfunding exemption if any person covered by the rule was involved in a "disqualifying event." Covered persons include:
  • The issuer, its predecessors and certain affiliates.
  • Any of the issuer's directors, officers, general partners or managing members.
  • Any 20% beneficial owner of the issuer (calculated by voting power).
  • Any promoter connected with the issuer at the time of sale.
  • Any compensated solicitor for the offering.
  • Any director, officer, general partner or managing member of a compensated solicitor for the offering.
The disqualifying events covered by the proposal are modeled on those of Rule 262, and include, among other things, certain securities-law related injunctions and restraining orders entered in the last five years and certain regulatory orders entered in the last ten years. Like the Rule 506 disqualification provision, the proposal would include an exception for disqualifying events that the issuer did not know of and, in the exercise of reasonable care, could not have known of.

Promoter Compensation

Under the proposal, if an issuer compensates a person to promote the offering through the crowdfunding intermediary's communication channels, the issuer must take reasonable steps to ensure the compensated promoter identifies itself as such.

Resale Restrictions

As mandated by Section 4A(e), securities purchased in a crowdfunding transaction cannot be resold for a period of one year, unless they are sold to the issuer, to an accredited investor, as part of a registered offering or to a family member of the purchaser in connection with certain events like death or divorce.

Safe Harbor for Insignificant Deviations

The proposal includes a safe harbor for issuers that attempt to comply with Section 4(a)(6) but fail to do so. The safe harbor is modeled in part on a similar provision in Rule 508 of Regulation D.

Other Issues

The proposal also includes rules on dealing with oversubscription, the setting of the offering price, the types of securities that may be offered and valuation.

Crowdfunding Securities Exempt from Section 12(g) Cap

Section 12(g) of the Exchange Act requires an issuer to register a class of equity securities (making the company a reporting company) when its assets and the number of record shareholders of that class of securities exceed certain thresholds. The JOBS Act added Section 12(g)(6) to the Exchange Act, requiring SEC rulemaking to exclude from Section 12(g)'s record holder calculation securities acquired in crowdfunding offerings.
Proposed Rule 12g-6 would permanently exempt from the record holder count securities issued in a Section 4(a)(6) offering. A crowdfunding issuer seeking to exclude a person from its record holder count would have the burden of demonstrating that person's securities were initially issued in a crowdfunding offering.

Framework for Crowdfunding Intermediaries

Section 4(a)(6)(C) requires crowdfunding offerings to be conducted through a broker or funding portal, in each case that complies with Section 4A(a) of the Securities Act. Section 4A(a) places certain requirements on these crowdfunding intermediaries, including, among other things, that they must:
  • Be registered with the SEC as a broker or funding portal. Under the proposal, a crowdfunding intermediary must register as a broker under Section 15(b) of the Exchange Act or as a funding portal under Securities Act Section 4A(a)(1) and proposed Rule 400 of Regulation Crowdfunding. The proposal sets out a process and form (Form Funding Portal) for funding portal registration, as well as other substantive requirements such as the requirement to have a fidelity bond in place. Non-US entities are not permitted to register as funding portals unless certain conditions are met, including the existence of regulatory information sharing arrangements between the foreign entity's jurisdiction and the SEC.
  • Prohibit their directors, officers and partners from having any financial interest in an issuer using their services. The proposal extends this prohibition to the intermediary itself, and also prohibits any of these parties from receiving a financial interest in an issuer as compensation for services related to an offering of the issuer's securities.
  • Provide investors with educational materials. The proposal includes detailed requirements for this information and how and when it must be made available.
  • Take measures to reduce the risk of fraud in crowdfunding offerings. The proposal would require intermediaries to:
    • have a reasonable basis to believe a crowdfunding issuer is in compliance with regulations and has set up a means to keep accurate records of the holders of its securities (for example, use of a direct registration system, legends on certificates or use of a registered transfer agent, although none of these are required); and
    • deny access to an issuer or offering the intermediary believes presents a potential risk of fraud. The proposal requires an intermediary to conduct certain background and regulatory checks on issuers and certain related parties.
  • Make available information about the issuer and the offering no later than 21 days before the first day securities are sold to any investor. Under the proposal, this would be satisfied by making the issuer's Form C (and related amendments and updates) available on the platform.
  • Ensure no investor exceeds the investment limits. The proposal would allow an intermediary to rely on an investor's representations about its income and net worth and total crowdfunding investments made in the last 12 months.
  • Allow investors to cancel their investment commitments. The proposal would implement this by requiring investors to be given an unconditional right to cancel their commitment for any reason until 48 hours before the deadline identified in the issuer's offering materials. The proposal includes a procedure for issuers to close an offering earlier than the deadline when it reaches its target funding amount before that time, subject to detailed conditions and notice periods. Additional notice and reconfirmation or cancellation requirements would apply when material changes to an offering occur, and when an offering is terminated.
While not required by statute, the proposal would require intermediaries to provide communication channels to permit discussions among investors and between investors and the issuer about offerings on the platform. The proposal includes detailed requirements for these channels. The proposal would also require intermediaries to send certain notices to investors.
The proposing release clarifies that a crowdfunding intermediary would not be required to register as a securities exchange or alternative trading system (ATS) solely because of its activities facilitating crowdfunding offerings. However, if the intermediary facilitated secondary market activity in securities issued under Section 4(a)(6), it would be required to register as an exchange or ATS if it met the criteria in Exchange Act Section 3b-16.
The proposal includes other requirements related to the relationship between intermediaries and crowdfunding investors, including requiring portals to take certain steps to preserve investor privacy. It also would provide safe harbors for funding portals from other provisions of the federal securities laws that could otherwise be implicated by funding portal activities. It would require funding portals to comply with certain federal anti-money laundering laws and impose recordkeeping requirements.

Status Funding Portal

In addition to creating the Section 4(a)(6) exemption, the JOBS Act also created a new status under the securities laws: the funding portal (see Section 3(a)(80) of the Exchange Act). Funding portals are Internet-based platforms or intermediaries that may facilitate crowdfunding offerings without having to register as brokers. The activities of a funding portal would, but for the Section 3(a)(80) exemption, cause the portal to meet the definition of broker under the Exchange Act. In order to qualify for the Section 3(a)(80) funding portal exemption, a funding portal may not:
  • Offer investment advice or recommendations.
  • Solicit purchases, sales or offers to buy securities displayed on the platform.
  • Compensate employees, agents or other persons for solicitation or based on sales.
  • Hold, manage, possess or otherwise handle investor funds or securities.
The JOBS Act allows the SEC to expand this list of prohibited funding portal activities, but the proposal declined to do so. However, under the proposal, both funding portals and their associated persons (including partners, officers, director and managers, control persons and non-ministerial employees) would be subject to these limitations.
Lastly, under the JOBS Act and the proposal, funding portals must be a member of a national securities association. Currently, FINRA is the only such association. For more information on FINRA rulemaking activity regarding funding portals, see Legal update, FINRA Issues Crowdfunding Portal Regulatory Notice and Proposed Rules.

Public Comments

The SEC is accepting public comments on the proposal until 90 days after it is published in the Federal Register.
For more information on the proposal, see the SEC's press release.
To learn more about Title III of the JOBS Act, see Practice Note, JOBS Act: Crowdfunding Summary.