by Trent Dykes and Nathan Luce
Earlier today, the Securities and Exchange Commission (SEC) took an important step in making securities-based crowdfunding a reality for many small companies with the release of its proposed rules governing crowdfunding. The proposed rules, called “Regulation Crowdfunding,” were drafted in connection with Title III of the JOBS Act. Whereas traditional crowdfunding involves a company offering things like advanced product or information releases, premium services or the ability to contribute to a given cause in exchange for an investment, Regulation Crowdfunding would allow those same companies to issue actual securities (i.e., debt or equity) in exchange for investments—a dramatic shift from what has become fairly common practice on websites such as Kickstarter or Microryza over the past few years.
The SEC’s Regulation Crowdfunding proposal would implement rules governing the offer and sale of securities under new Section 4(a)(6) of the Securities Act of 1933 (Section 4(a)(6)). The proposal also provides a framework for the regulation of registered funding portals and brokers, whom issuers must use as intermediaries in their crowdfunding efforts pursuant to Section 4(a)(6). In addition, the proposal would exempt securities sold pursuant to Section 4(a)(6) from the registration requirements of Section 12(g) of the Securities Exchange Act of 1934.
Current SEC regulations on general solicitation, advertising, and purchaser qualification requirements have made private placement exemptions generally unavailable in the crowdfunding context, as most crowdfunding efforts are traditionally broad-based and not necessarily limited to investors who meet specific qualification requirements (e.g., investors who qualify as “accredited investors”). Further, as discussed in the SEC’s proposal, third parties who operate websites to effect the purchase and sale of securities for the account of others generally would—under existing SEC regulations—need to register with the SEC as a broker-dealer and comply with the various laws and regulations applicable to broker-dealers. This can be impractical for startups and other small businesses, particularly when one considers the various financial and regulatory burdens associated with registration as a broker-dealer.
The proposed rules would implement Section 4(a)(6), which provides an exemption from the registration requirements of Securities Act Section 5 for certain crowdfunding transactions. To qualify for the exemption under Section 4(a)(6), crowdfunding transactions by an issuer must meet specified requirements, including the following:
Issuers will also need to comply with a variety of disclosure requirements, which must be filed with the SEC on the EDGAR database and made available to investors, intermediaries, and potential investors. Many of the proposed disclosures are high-level informational items—basic information such as names of company officers, number of employees, nature of the business, and company ownership. Other disclosure requirements, however, are more onerous. For example, if the company’s target offering is $100,000 or less, the disclosure must include the income tax returns filed by the issuer for the most recently completed year and financial statements of the issuer, which must be certified by the principal executive officer of the company. If the target offering amount between $100,000 and $500,000, it must provide financial statements reviewed by an independent accountant. And, if the target offering amount happens to exceed $500,000, the proposed rules would require the company to provide more formal audited financial statements—a fairly significant cost for most companies.
Notably, under the proposed rules, many of these disclosures are not “one time” requirements—under Section 227.202 of the proposed rules, once an issuer has offered and sold securities under Section 4(a)(6), it must continue to report certain financial statements and make a number of other continuing disclosures (both with the SEC and on the issuer’s website). Companies considering crowdfunding should realize that the information provided to the SEC may become public or accessible by people—other than your investors and the SEC—with whom you might not otherwise share the information (e.g., competitors, tax authorities, law enforcement, potential private litigants and plaintiff attorneys, etc.). These ongoing reporting requirements will continue until (i) the issuer becomes a reporting company required to file reports under Section 13(a) or Section 15(d) of the Exchange Act, (ii) the issuer or another party repurchases all of the securities issued in reliance on Section 4(a)(6) including any payment in full of debt securities or any complete redemption of redeemable securities, or (iii) the issuer liquidates or dissolves its business in accordance with state law.
The proposed rules also contain a number of suggested regulations that would apply to funding portals—e.g., website operators who serve as intermediaries between the company and the various investors. For example:
Please note that until the SEC adopts the final rules relating to crowdfunding transactions and such rules become effective, issuers and intermediaries may not rely on the exemption provided under Regulation Crowdfunding or Section 4(a)(6). The SEC is currently accepting comments on the proposed rules, and although there is no guarantee as to when the final rules will go into effect, it could take over a year before the rules are implemented (for example, the SEC’s rules regarding general solicitation went into effect in September of 2013, and were introduced just over a year earlier, in August of 2012).
The full 585-page release on Regulation Crowdfunding covers a number of other important issues, including advertising and promoter compensation, among others. It can be found here. We will continue to monitor the proposed rules over the coming weeks and months and will provide a more detailed summary as the proposals solidify.
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