Today, I would like to discuss
regulatory aspects of crowdfunding. There are several proposals now that aim to
change existing regulation to provide small businesses with easier access to
One such proposal comes from the Sustainable Economies Law Center (SELC). In
July 2010, SELC proposed to the SEC to exempt from registration requirements of
Section 5 of the Securities Act securities offerings up to $100,000 in total
amount raised with a $100 maximum investment limit per investor. Investors can
be only individuals and must be either U.S. citizens or permanent residents.
Investors cannot participate in multiple offerings at the same time. Petition
is available at www.sec.gov/rules/petitions/2010/petn4-605.pdf.
In my opinion, the SELC proposal is not practical in limiting investment amount
to only $100 per investor. A $10,000 limit is much more reasonable, and if
lost, would unlikely lead to investor's bankruptcy. Also, the rationale for
limiting investors only to one offering at a time is unclear. After all, if
they are choosing to participate in risky investments, then they have to be
prepared to bear the risks (especially, if the investments are limited to
Another proposal is called the "Startup Exemption". The petition (that
presently has 1,803 signatories) is based on an idea by a group of
entrepreneurs led by Sherwood Neiss. It calls for creating a "funding window"
to raise up to $1 million over the life of a business, to be used by small
businesses with less than $5 million in revenues during the last three years.
Each individual investment would be limited to a maximum of $10,000. Investors
would be required to fill out a questionnaire demonstrating their willingness
to accept risks related to the investment. The Startup Exemption also proposes
to eliminate the 500-shareholder rule limitation and the broker-dealer
licensing requirements and preempt state regulation of such offerings similarly
to Rule 506. Finally, the petition calls to repeal the ban on general
solicitation if the offering is conducted through one of registered platforms,
where like on crowdfunding sites, ideas can be vetted, discussed, and peer
reviewed. Such platforms would then report to the SEC regarding their customers
and offerings. More information is available at www.startupexemption.com.
This seems to be a better proposal as it addresses important issues like state
regulation, the 500 shareholder rule, and proposes a more reasonable $10,000
per investment limit. Also, reporting requirements by registered platforms that
would be reviewed by the SEC, as well as review of companies and offerings by
peers, provide some investor protection and transparency.
I identify two paramount issues in all the discussions about the need for new
exemptions. First, there is an acute need to protect investors from scams and
fraud that may be directed at them once/if general solicitation on the Internet
is allowed. It seems inevitable that at some point in the future the SEC will
relax the ban on solicitation and advertising given the proliferation of social
media and the current state of technological progress. However, this also may
open a floodgate of fraudulent offerings and schemes, and the SEC needs to put
safeguards in place before it relaxes rules relating to solicitation and advertising.
Second, one of the main complaints regarding the current private placement
exemptions is the onerous state regulation of private offerings. The only
private offerings that are preempted from state regulation by the National
Securities Markets Improvement Act of 1996 (the "1996 Act") are the Rule 506
offerings. State regulation is based on the number of investors in each state.
So, a private offering of securities to investors from ten or so states may
fall under regulation of all ten states, thus leading to high legal fees which
may make a small offering cost-prohibitive. There is a need to expand the
reaching of the 1996 Act to other Regulation D offerings (Rule 504 and 505
offerings) as well as other private placement exemptions.
In the April 6, 2011 26-page long letter to the Chairman of the Committee on
Oversight and Government Reform, Mary Shapiro, the Chairman of the SEC,
expressed the understanding and the urgency for legal reform to enable small
company investing. The SEC is currently reviewing the impact of the regulations
on capital formation for small business, with the focus on (i) restrictions on
communications in IPOs, (ii) adequacy of a ban on solicitation and advertising
in light of current technologies and capital-raising trends, (iii) the 500
shareholder trigger for public reporting, and (iv) the questions presented by
new capital raising strategies. The SEC staff is familiar with crowdfunding and
the desire by many startups to use it to conduct securities offerings (i.e.,
offer equity or profit sharing or another arrangement to investors).
So, stay tuned, as the Congress and the SEC address issues relating to capital
formation of small businesses.
Read more commentary from Arina Shulga on the
legal aspects of operating new and growing businesses at Business Law Post.
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