Alternative Financing Joins The Crowd – Part Two

By Audris G. Hampton, Esq
Posted on 1-17-2014
CATEGORIES: Business Law

I disclosed in Part 1 of this article-series, that the Jumpstart Our Business Startups Act of 2012 (the JOBS Act) eliminated the ban on general solicitation and advertising in the private placement of securities. I also disclosed that Title III of the JOBS Act created a securities-law exemption for the offer and sale of securities through crowdfunding (the CROWDFUND Act).

At the conclusion of Part 1, I referenced the twofold purpose that underlies the CROWDFUND Act: One, Congress intended to facilitate the use of peer-to-peer financing networks, accessible via internet portals; and, two, Congress intended to open up to “non-accredited” investors a financing-market for small, innovative (albeit speculative), business startups.

I advised in Part 1 that I next would focus upon the actual SEC proposals and recommendations. Just prior to publishing Part 1 of this article-series, the SEC issued a press release entitled, “SEC Issues Proposal on Crowdfunding” (2013-227 Washington D.C. Oct. 23, 2013; “SEC Proposal”). That SEC Proposal, and the below-referenced information, are the primary sources from which I derived the informational-content that I reference and disclose in this Part 2 of the article-series.

The JOBS Act established the foundation for crowdfunding. The JOBS Act went into effect on Sept. 23, 2013. On October 23, 2013, the SEC unanimously voted to propose rules that would implement the JOBS Act by providing a regulatory and administrative structure for crowdfunding. The public-comment phase of the proposed Rules closed this past January 2014.

SEC Chair Mary Jo White emphasized that the JOBS Act presents new capital-investment opportunities for small businesses and for a wide range of potential investors. White advised, “There is a great deal of excitement in the marketplace about the crowdfunding exemption, and I’m pleased that we’re in a position to seek public comment on a proposal to permit crowdfunding. …We want this market to thrive in a safe manner for investors.”

The opportunity for public comment upon the rules remained available for 90-days following the October 23, 2013 publication of the rules (in the Federal Register). I derived the following excerpts, explanations, and comments from information that the SEC made available, through the “Open Meeting” process, in developing the FACT SHEET (and Background Information) in support of the October 23, 2013 proposal, publication, meeting, and public-comment process.

(Acknowledged) Purpose of the Proposed Rules:

Title III of the JOBS Act establishes a foundation for a regulatory structure that permits small businesses to utilize crowdfunding. The exemption requires the SEC to write rules to implement the exemption; and the exemption establishes a new entity, the “funding portal”, through which intermediaries, acting through internet-based platforms, may facilitate the offer and sale of securities, without being registered “brokers”. Congress intends for these combined measures to facilitate capital-raising by small businesses, while providing significant protections to investors.

The primary functions of the Proposed Rules:

The proposed rules:

(1) permit individuals to invest (in accordance with certain thresholds);

(2) limit the amount of money companies can raise;

(3) require companies to disclose certain information about their offers; and

(4) create a regulatory framework for the intermediaries (broker-dealers and funding-portals) that facilitate the crowdfunding transactions.

Particular qualifications and conditions under the Proposed Rules:

• One million dollar crowdfunding/per annum cap:
• A company would be able to raise a maximum aggregate amount of $1 million, through crowdfunding offerings, within a 12-month period.
• Investors with less than $100,000.00 in annual income/net assets:
• Investors, over the course of a 12-month period, will be permitted to invest up to $2,000 or five percent of their annual income or net worth, whichever is greater, if both their annual income and net worth are less than $100,000.
• Investors with $100,000.00, or more, in annual income/net assets:
• Investors, over the course of a 12-month period, will be permitted to invest up to 10 percent of their annual income or their net worth, whichever is greater, if either their annual income or their net worth is equal to or more than $100,000. However, during the 12-month period, these investors would not be able to purchase more than $100,000 of securities through crowdfunding.

Only certain companies are eligible for crowdfunding:

Certain companies would not be eligible to use the crowdfunding exemption.

Ineligible companies include:

(1) non-U.S. companies;

(2) companies that already are SEC-reporting companies;

(3) certain investment companies;

(3) companies that are disqualified specifically under the proposed disqualification rules;

(4) companies that have failed to comply with the annual reporting requirements in the proposed rules; and

(5) companies that have no specific business plan or have indicated their business plan is to engage in a merger or acquisition with an unidentified company or companies.

One-year non-resale period:

Title III of the JOBS Act prohibits the reselling of securities, purchased in a crowdfunding transaction, for a period of one year from the date of purchase/investment. However, the holders of these crowdfunding-securities are not “counted’ in the (number-of-holders) threshold that requires a company to register with the SEC under Section 12(g) of the Exchange Act.

Disclosure by Companies:

The proposed rules will impose upon companies conducting a crowdfunding-offering the obligation to file with the SEC, provide to the actual investors, and provide to the intermediary that is facilitating the crowdfunding-offering, certain information which the companies also must make available to potential investors.

• A company will be required to disclose, in its offering-documents, the following:
• A company must provide information about officers, directors, and owners (owners of 20 percent or more of the company).
• A company must provide a description of the company’s business and the intended use of proceeds from the crowdfunding-offering.
• A company must provide to the public the price of the securities being offered, the target offering amount, the deadline to reach the target offering-amount, and whether the company will accept investments in excess of the target offering-amount.
• A company must provide specific information regarding certain “related-party” transactions.
• A company must provide a description of the financial condition of the company.
• A company must provide the financial statements of the company. Depending upon the amount offered and sold, during a 12-month period, the financial statements would have to be accompanied by a copy of the company’s tax returns, reviewed or audited by an independent public accountant or auditor (explained, below, more fully).
• A company will be required to amend its offering-documents to reflect material changes and provide updates on the company’s progress toward reaching the target offering-amount.
• A company relying upon the crowdfunding exemption to offer and sell securities will be required to file with the SEC, and provide to investors, an “Annual Report”.

Crowdfunding Platforms:

One of the key investor protections that Title III of the JOBS Act provides for crowdfunding is the requirement that crowdfunding transactions take place through an SEC-registered intermediary, either a “broker-dealer” or a “funding-portal”. Under the proposed rules, the offerings will be conducted online, exclusively, through a platform operated by a registered broker-dealer or a funding portal, which will be a new type of SEC registrant.

• The proposed rules will impose upon SEC-registered broker-dealers and funding-portals the following obligations:
• The broker-dealers and funding-portals must provide investors with educational materials.
• The broker-dealers and funding-portals must take approved measures to reduce the risk of fraud.
• The broker-dealers and funding-portals must make available to a potential investor certain information about the issuer (the company) and the offering (the crowdfunding-transaction).
• The broker-dealers and funding-portals must provide communication channels to permit potential investors to engage meaningfully in discussions about offerings on the platform.
• The broker-dealers and funding-portals must facilitate, directly, the actual offer and sale of crowdfunded-securities.
• The proposed rules will impose upon funding-portals the following restrictions:
• The funding-portal may not offer investment “advice” or make funding “recommendations”.
• The funding-portal may not “solicit” purchases, sales, or offers to buy securities offered or displayed on its website.
• The funding-portal may not hold, possess, or handle investor funds (or exchanged securities).

The proposed rules also will impose upon the funding-portal certain restrictions on compensating third-parties for the solicitation of crowdfunded-securities-offers.

Along with the imposed restrictions and limitations, the proposed rules will provide “safe harbor” definitions, descriptions, and guidelines. If funding-portals comply with the safe harbor provisions, then the funding-portals can engage in certain activities that are deemed consistent with the restrictions, even if, arguably, one could reasonably reach a different conclusion about whether the activities are permitted.

What has transpired and what will next happen:

Now that the Commission has sought public comment on the proposed rules for 90 days, the Commission will next review the comments and determine whether to adopt the proposed rules.

The new CROWDFUND Act has important limitations and places significant obligations on participants in this new, alternative-investment market. Under the statute, as mentioned above, issuers (companies) may only raise up to $1,000,000, annually, through securities-crowdfunding. However, in addition to the monetary limitation, issuers also must state a minimum amount for the offering and can collect the proceeds of the offering only if they reach or exceed that target.

The financial disclosures that the issuers must provide will depend on the size of the offering: For offerings of $100,000 or less, issuers will be required to produce income tax returns for the last fiscal year and unaudited financial statements that are certified as accurate by the principal executive officer; for offerings of between $100,000 and $500,000, issuers will be required to produce financial statements that are reviewed by an independent, certified public accountant; and for offerings of between $500,000 and the $1 million maximum, the issuer will be required to produce fully-audited financial statements. Finally, all issuers must follow-up each crowdfunding offering by filing with the SEC, and making available to investors, annually, a report on the results of crowdfunding-transactions.

As for investors, the maximum, annual aggregate-amount of crowdfunded-securities that any one investor may purchase depends on her wealth and income: If an investor’s net worth or annual income is under $100,000, she can invest the greater of $2,000, or five percent of her annual income, in crowdfunded-securities each year; if her net worth or annual income equals or exceeds $100,000, she can invest 10% of her annual income each year (as above-referenced).

The Act provides that crowdfunding-transactions may not be consummated directly between an issuer and an investor. Rather, the transactions must be executed through a financial intermediary registered with the SEC as either a broker-dealer or a funding portal (as referenced above, the Act specifically “creates” these new types of intermediaries). Also alluded-to, above, the Act imposes a number of serious obligations on these financial intermediaries, such as the requirement to take approved measures to reduce the risk of fraud – expressly including a background check on officers, directors and substantial investors in the crowdfunding-issuers.

With respect to a secondary market, for crowdfunded-securities that are not part of an SEC-registered offering, the Act provides that the original investors/purchasers may not sell, or otherwise transfer, any crowdfunded-securities, for a period of one year after the date of the investment/purchase, unless the original investor is transferring-back to the issuer (the company), an accredited investor, or a family member of the original purchaser, the crowdfunded-securities.

The CROWDFUND Act expressly pre-empts state law regarding the registration or qualification of securities. However, the companies/issuers must provide states with notice of crowdfunded-offerings; and each state retains the right to bring an enforcement action for fraud or other violations of state securities-law (i.e., laws that are not related to registration).

To police fraudulent behavior, the Act expressly authorizes civil actions against an issuer – and, specifically, its officers and directors – if an officer or director makes an untrue statement of a fact that is material to the offering. In addition, the SEC is granted examination, enforcement and other rulemaking authority over dealer-brokers/funding-portals, and presumably retains authority to enforce the various statutory and regulatory mandates for both issuers and intermediaries.

How securities-crowdfunding will play out, in actual practice, remains to be seen and depends greatly upon the rules that the SEC just proposed on October 23, 2013. Those proposed rules, called “Regulation Crowdfunding,” are available online.

The CROWDFUND Act represents an opportunity for enterprising and entrepreneurial individuals and businesses to shape a new alternative-financing/creative-investment market for securities. There will be original and exciting opportunities to facilitate a process that literally could “open many doors”. Crowdfunding has the potential to accommodate, for the first time, the capital/cash needs of impassioned-visionaries who love what they do and live to “be different” and “make a difference”. The possibilities, alone, are amazing and inspiring!