SEC Adopts Final Crowdfunding Rules | Practical Law

SEC Adopts Final Crowdfunding Rules | Practical Law

The SEC adopted final rules and forms implementing Title III of the JOBS Act, the crowdfunding provision.

SEC Adopts Final Crowdfunding Rules

Practical Law Legal Update w-000-7284 (Approx. 11 pages)

SEC Adopts Final Crowdfunding Rules

by Practical Law Corporate & Securities
Published on 05 Nov 2015 • USA (National/Federal)
The SEC adopted final rules and forms implementing Title III of the JOBS Act, the crowdfunding provision.
On October 30, 2015, the SEC adopted final rules and forms implementing 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. On October 23, 2013, the SEC issued proposed rules and forms for the implementation of Title III (see Legal Update, SEC Proposes Crowdfunding Rules).
The final rules and forms adopted on October 30, 2015 maintain the basic structure of the SEC's 2013 proposal but introduce some key changes based on feedback received by the SEC during the public comment period. The final rules and forms will become effective 180 days after publication in the Federal Register. Form Funding Portal and certain amendments to Form ID, however, will become effective January 29, 2016.
The final crowdfunding rules and forms include:
  • Regulation Crowdfunding, a new regulation that:
    • governs offerings made in reliance on the Section 4(a)(6) crowdfunding exemption from Securities Act registration;
    • provides a framework for the operations of crowdfunding intermediaries, including funding portals and brokers, and creates a registration regime for funding portals;
    • places restrictions on the resale of securities sold in Section 4(a)(6) offerings; and
    • exempts securities sold in Section 4(a)(6) offerings from counting toward the Exchange Act registration threshold in Section 12(g) (see Practice Note, Exchange Act Registration: Overview: Calculating Size Thresholds Under Section 12(g)).
  • Form C, a new form that issuers in Section 4(a)(6) offerings are required to file with the SEC:
    • before the commencement of a Section 4(a)(6) offering;
    • during the pendency of a Section 4(a)(6) offering, to report progress toward the funding goal (if the issuer's intermediary does not make such updates publicly available on its platform) and, when applicable, to report material changes to the offering or updates;
    • annually, after completing a Section 4(a)(6) 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) must file to register with the SEC, update information and terminate their registration.
On October 23, 2013 (the same day the SEC released its proposed crowdfunding rules), 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). On October 9, 2015, FINRA filed its revised proposed rules for funding portals with the SEC (see Legal Update, FINRA Proposes Crowdfunding Portal Rules).
The term "crowdfunding" is used colloquially to refer to several fundraising practices, including some techniques that do not count as offers and sales of securities under federal law and other techniques that are considered securities offerings but that rely on exemptions from Securities Act registration other than Section 4(a)(6) (for more information, see Article, Expert Q&A on Equity Crowdfunding 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.

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 per issuer and amounts invested per individual. Regulation Crowdfunding is designed to help issuers and investors apply these statutory limits:
  • Application of the $1 million per issuer, per year crowdfunding cap. Only securities sold under Section 4(a)(6) (and not any other exemption from registration) count towards an issuer's $1 million limit on capital raised through crowdfunding. In calculating the limit, an issuer is 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 was significant ambiguity in the statutory language limiting the amount an issuer may sell in any one year to any single investor in crowdfunding offerings, and the SEC's final rules resolve that ambiguity. Each investor is permitted to invest no more than the following amounts in Section 4(a)(6) offerings across all issuers in any rolling 12-month period:
    • for individuals with either an annual income or net worth that is less than $100,000, the greater of (i) $2,000 and (ii) 5% of the lesser of the investor's annual income and net worth; and
    • for individuals with both an annual income and net worth of at least $100,000, 10% of the lesser of the investor's annual income and net worth (not to exceed an amount sold of $100,000 to each individual).
    Annual income and net worth are calculated in accordance with the SEC's rules for determining whether an individual is an accredited investor.
    The new rules permit crowdfunding issuers to rely on the efforts of crowdfunding intermediaries to determine whether an investor has reached the individual limits (provided that the issuer does not have actual knowledge to the contrary).

Disclosure and Financial Statement Requirements

Section 4A(b)(1) of the Securities Act requires issuers relying on the Section 4(a)(6) exemption for conducting 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 final rules, a crowdfunding issuer is required to prepare and file a Form C on EDGAR before the commencement of the offering. Among other things, Form C will include information on:
  • The issuer itself, including name, physical address, type of entity and website address.
  • 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 final rules do not specify the disclosures that an issuer must include in the description of the business and the business plan, and the SEC declined to provide a non-exclusive list of the types of information an issuer should consider disclosing.
  • The use of proceeds.
  • The target offering amount and deadline to reach it. Issuers are also 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. The issuer is also required to provide other information, including about how the securities are being valued and the risks of being a minority owner.
  • The following matters (these disclosure requirements are not directly required by statute):
    • the intermediary for the offering, the compensation being paid to the intermediary, and any direct or indirect interest (or arrangement to acquire an interest) in the issuer held by the intermediary;
    • the location on the issuer's website where its annual report will be made available (and the date by which the report will become available each year);
    • whether the issuer (or any of its predecessors) previously failed to comply with the ongoing reporting requirements of Regulation Crowdfunding;
    • number of current employees of the issuer;
    • legends;
    • risk factors;
    • material terms of the issuer's indebtedness;
    • exempt securities offerings of the issuer in the last three years;
    • certain related party transactions since the beginning of the issuer's last fiscal year; and
    • any material information necessary in order to make the statements made in the Form C disclosure, in light of the circumstances under which they were made, not misleading.
The final rules 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 the amount of total income, taxable income, and total tax as reflected in the issuer's federal income tax returns (in lieu of filing a copy of the tax returns, as originally proposed) for the most recently completed fiscal year (if any), in both cases certified true and complete by the issuer's principal executive officer.
    If the issuer has financial statements that have been reviewed or audited by an independent public accountant, the issuer must include those financial statements instead and will no longer be required to include its tax return information or certification from its principal executive officer.
  • 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. If the issuer has audited financial statements, it must include those instead.
  • Offerings over $500,000. The first time an issuer conducts an offering of more than $500,000 but not more than $1 million under Regulation Crowdfunding, it will be subject to the same financial statement requirements as issuers raising between $100,000 and $500,000.
    For issuers that have previously sold securities in reliance on Regulation Crowdfunding, the issuers must provide US GAAP financial statements audited (in accordance with AICPA or PCAOB standards) by an independent auditor, accompanied by the audit report.
An issuer is also required to provide on Form C a narrative discussion of its financial condition covering, among other things, its historic results of operations and liquidity and capital resources. The SEC expects this discussion to be similar to MD&A, but generally not as lengthy or detailed considering the more limited operating history, complexity and scale of likely crowdfunding issuers.
In addition, the final Form C includes an optional Question and Answer format that issuers may use to provide certain disclosures. In this format, issuers prepare their disclosures by answering the questions provided in Form C and filing that disclosure as an exhibit to the Form C.
A crowdfunding issuer is required 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 is also required to amend its disclosure if a material change or update occurs (on a filing designated Form C/A).
Each Section 4(a)(6) issuer will 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 will include information similar to the offering statement on Form C, including financial statements and the narrative disclosures of its financial condition, but excluding offering-specific information. Regardless of the amount raised under Regulation Crowdfunding, however, Form C-AR does not require reviewed or audited financial statements from issuers that do not prepare those statements for other purposes. If reviewed or audited financial statements are unavailable, the issuer may include financial statements certified true and complete by its principal executive officer.
The annual reporting requirement continues until one of the following events occurs:
  • The issuer becomes a reporting company.
  • The issuer has filed at least one annual report on Form C-AR and has fewer than 300 holders of record.
  • The issuer has filed at least three annual reports and has total assets of no more than $10 million.
  • 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 is required to file a notice of termination of its annual reporting obligation on Form C-TR within five business days of becoming eligible for terminating those obligations.

Advertising and Communications

Under the final rules, issuers are only permitted to advertise their offerings through a notice containing certain specific limited information (similar to "tombstone ads" complying with Rule 134 under the Securities Act). The notice must direct readers to the crowdfunding intermediary platform for the offering. Potential investors can then access additional information about the offering through the platform. The notice may be in print or distributed electronically, including through social media or the issuer's website.
However, there is 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 can continue to advertise its products or services).

Integration Mechanics

Section 4(a)(6) offerings will not be integrated with any other exempt offerings by the issuer, as long as each offering complies with its respective exemption. For instance, 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 (such as under Rule 506(b) of Regulation D), the issuer would need to be satisfied that investors in the latter offering became interested in that offering through means other than the general solicitation undertaken in connection with the Section 4(a)(6) crowdfunding offering. On the other hand, if an issuer using general solicitation in an offering under Rule 506(c) of Regulation D advertises that offering while undertaking a concurrent Section 4(a)(6) crowdfunding offering, that advertisement must comply with the more restrictive solicitation requirements of Regulation Crowdfunding.

Public Accessibility

The final rules include two requirements intended to ensure Section 4(a)(6) crowdfunding offerings permit public access to information about the offering and information sharing among the "crowd." The rules require that each offering be conducted using only one intermediary and that 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 following issuers are also ineligible to rely on Section 4(a)(6) under the final rules:
  • Issuers that failed to make required Form C filings in the two years before a crowdfunding offering (though the exemption becomes available again once the issuer makes any missed filings).
  • 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 final rules 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).
An issuer is unable to rely on the crowdfunding exemption if any "covered person" 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 final rules 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 final rules 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

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. Intermediaries are also required to inform investors that compensated promoters are required to identify themselves as such in any communications with investors.

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, to a family member (or trust for the benefit of a family member) of the purchaser, or in connection with certain events like death or divorce.

Safe Harbor for Insignificant Deviations

The final rules include 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

Regulation Crowdfunding 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.
New Rule 12g-6 permanently exempts from the record holder count securities issued in a Section 4(a)(6) offering, as long as the issuer:
  • Is current in its ongoing annual reports required under Regulation Crowdfunding.
  • Has total assets as of the end of its last fiscal year of no more than $25 million.
  • Has engaged the services of a transfer agent SEC-registered pursuant to Section 17A of the Exchange Act.
A crowdfunding issuer seeking to exclude a person from its record holder count has 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. 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 Rule 400 of Regulation Crowdfunding. The new rules set out a process and form (Form Funding Portal) for funding portal registration, as well as other substantive requirements. 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 (including, under the final rules, a financial interest received as compensation for providing the intermediary's services to the issuer in connection with a crowdfunding offering). While the proposed rules extended this prohibition to the intermediary itself, the final rules permit an intermediary to have a financial interest in a crowdfunding issuer if:
    • the intermediary receives the financial interest as compensation for the services provided to the issuer in connection with a crowdfunding offering conducted through the intermediary's platform; and
    • the financial interest consists of securities of the same class and having the same terms, conditions and rights as the securities the company issues to crowdfunding investors through the intermediary's platform.
  • Provide investors with educational materials. The final rules include 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 final rules require intermediaries take certain affirmative anti-fraud measures, including:
    • conducting background and securities enforcement regulatory checks on issuers and certain related parties; and
    • denying access to an issuer or offering the intermediary believes presents a potential risk of fraud.
    The final rules also require that intermediaries have a reasonable basis to believe a crowdfunding issuer is:
    • in compliance with crowdfunding regulations; and
    • has set up a means to keep accurate records of the holders of its securities.
    An intermediary will be deemed to have satisfied the requirement that its issuers have adequate recordkeeping systems if the issuers engage the services of a transfer agent that is registered under Section 17A of the Exchange Act.
  • Make available information about the issuer and the offering no later than 21 days before the first day securities are sold to any investor. This may be satisfied by making the issuer's Form C (and related amendments and updates) available on the intermediary's platform.
  • Ensure no investor exceeds the investment limits. Intermediaries can rely on an investor's representations about its income, net worth, and total crowdfunding investments made in the last 12 months through any crowdfunding intermediary.
  • Allow investors to cancel their investment commitments. Crowdfunding intermediaries must give investors an unconditional right to cancel their commitment for any reason until 48 hours before the deadline identified in the issuer's offering materials. The final rules include 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 apply when material changes to an offering occur and when an offering is terminated.
While not required by statute, the final rules require intermediaries to provide communication channels to permit discussions among investors, and between investors and the issuer, about offerings on the platform. The rules include detailed requirements for these channels. The rules also require intermediaries to send certain notices to investors.
The final rule release clarifies that a crowdfunding intermediary will 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 facilitates secondary market activity in securities issued under Section 4(a)(6), it will be required to register as an exchange or ATS if it meets the criteria in Exchange Act Section 3b-16.
The final rules include other requirements related to the relationship between intermediaries and crowdfunding investors, including requiring portals to take certain steps to preserve investor privacy. The rules also provide safe harbors for funding portals from other provisions of the federal securities laws that could otherwise be implicated by funding portal activities.

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.
Funding portals and their associated persons (including partners, officers, director and managers, control persons and non-ministerial employees) are subject to these statutory limitations. The SEC, however, created a safe harbor in the final rules for funding portals to carry certain specified activities.
Lastly, under the JOBS Act and the final rules, 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 Proposes Crowdfunding Portal Rules.
To learn more about Title III of the JOBS Act, see Practice Note, JOBS Act: Crowdfunding Summary.