Crowdfunding issuers. Title III of the JOBS Act amends Section 4 of the Securities Act to create a new exemption for offerings of “crowdfunded” securities. Specifically, the JOBS Act amends Section 4 of the Securities Act to exempt issuers from the requirements of Section 5 of that Act when they offer and sell up to $1 million in securities, provided that individual investments do not exceed certain thresholds, and that the issuer satisfies other conditions in the JOBS Act, some of which will require rulemaking by the SEC.
One of these conditions is that issuers must use the services of an intermediary that is either a broker registered with the SEC or a “funding portal” registered with the SEC.
Funding portals. Title III of the JOBS Act adds new Section 3(h) to the Exchange Act which requires the SEC to exempt, conditionally or unconditionally, an intermediary operating a funding portal from the requirement to register with the SEC as a broker. The intermediary, though, would need to register with the SEC as a funding portal and would be subject to the SEC’s examination, enforcement, and rulemaking authority. The funding portal also must become a member of a national securities association that is registered under Section 15A of the Exchange Act.
A funding portal is defined as a crowdfunding intermediary that does not:
(i) offer investment advice or recommendations;
(ii) solicit purchases, sales, or offers to buy securities offered or displayed on its website or portal;
(iii) compensate employees, agents, or others persons for such solicitation or based on the sale of securities displayed or referenced on its website or portal;
(iv) hold, manage, possess, or otherwise handle investor funds or securities; or,
(v) engage in such other activities as the SEC, by rule, determines appropriate.
The JOBS Act directs the SEC to adopt rules to implement Title III within 270 days of enactment of the Act. The President signed the JOBS Act into law on April 5, 2012. Although the 270-day period has come and gone, the deadline has not been met nor is there a definitive timeline in place as of the writing.
What is Equity-Based Crowdfunding?
‘Crowdfunding, or to be more specific, ‘equity-based crowdfunding’ is not yet legal. Under the current regulatory framework, the only legal way to raise money from the public (i.e., securities-based crowdfunding) needs to be based on one of the following primary registration processes:
Small Corporate Offering Registration
NASAA revised the Form U-7 Disclosure Document on September 28, 1999. The revised Form U-7 has not been adopted by the Securities and Exchange Commission for use as the disclosure document in connection with Regulation A. If you intend to qualify your offering of securities under SEC Regulation A using Model A as the disclosure document, you may be required to use Form U-7, Small Corporate Offering Registration, adopted April 29, 1989.
The SCOR Form is not available for use in connection with every type of securities offering. The Form was designed for use by companies intending to raise capital through a public offering of securities exempt from registration with the U.S. Securities and Exchange Commission (SEC) under SEC Regulation A, Rule 504 of SEC Regulation D (“Rule 504″), or Section 3(a)(11) of the Securities Act of 1933. Your completed SCOR Form will become the main disclosure document for offerings being registered in all states accepting SCOR. A Company offering its securities under SEC Regulation A should check with the SEC to determine whether the SCOR Form may be used as the disclosure document.
The SCOR Form does not have Items that cover all types of industries and businesses. If the Items in the SCOR Form do not cover all the important areas of disclosure about your Company or its business, you may find it necessary to add material disclosure to Item 117, Other Material Factors.
The SCOR offering allows for the raising of up to $1,000,000 based on a State level registration. The process is a ‘fill-in-the-blanks’ form based on truthful, common sense answers and with the involvement of general legal and accounting services. Not all States have approved this process, and it can be complicated to file in multiple States due to conflicting local rules. Once the registration becomes effective, you are able to sell the securities to the general public.
Overall, offerings under Regulation A are often characterized as “mini registration statements” or “mini-public offerings” in that such offerings possess the general similarities to an offering undertaken pursuant to a full registration statement such as Form S-1 (the securities are freely tradable and general solicitation is allowed, etc.). However, unlike a full registration statement, the use of the Regulation-A exemption does not trigger filing obligations under Section 15(d) of the Securities Exchange Act of 1934 (the “1934 Act”), or any of the other “full bore” burdens of The Sarbanes-Oxley Act.
The Regulation-A offering is a Federal registration that will require filings at the State level. Not all States will accept the filing and will require their own review under applicable state law. It is important to understand your local State laws and check with state regulators to insure that you are fully compliant with all state requirements and mandated procedures. Present rules allow the maximum of $5,000,000 in any 12 month period. It also is a fill-in-the-blank form, but is very difficult to prepare without qualified legal counsel and accountants. It is not a process for everyone. Once the registration becomes effective, you are able to sell the securities to the general public.
Registration Statement S-1
This is the initial registration form for new securities required by the Securities and Exchange Commission (SEC) for public companies. Any security that meets the criteria must have an S-1 filing before shares can be listed on a national exchange. Form S-1 requires companies to provide information on the planned use of capital proceeds, detail the current business model and competition, as well as to provide a brief prospectus of the planned security itself, offering price methodology, and any dilution that will occur to other listed securities. The SEC also requires the disclosure of any material business dealings between the company and its directors and outside counsel.
Form S-1 is also known as the ‘Registration Statement under the Securities Exchange Act of 1933’. The S-1 registration is a Federal transaction that takes a company public, and requires State blue-sky filing to sell securities in numerous States thru licensed FINRA brokers, or by the officers and directors of the issuer. There is no limit to the capital than may be raised. This is a very detailed and time-consuming process that requires significant levels of professional input and involvement to complete, and will be expensive for the uninformed. Once the registration becomes effective, you are able to sell the securities to the general public.
Each of these registrations has different requirements to become fully compliant. Each requires reasonable to lengthy disclosure with enforceable liability for omission and or misleading material. Each of these will require legal, accounting and advisory professionals to improve the chances for a successful conclusion. Neither of these is easy or inexpensive in time and cost and none carry a guarantee of a successful conclusion.
Each of these is a legal form of crowdfunding, allowing solicitation of the public for investment if and only if you are fully compliant with the individual regulations of both State and Federal governments.
Equity crowdfunding today can create and does create absolute liability for everyone from the issuer to service providers if a proper registration is not rigorously done under the current regulatory framework.
Once the rules are completed by the Securities and Exchange Commission (SEC) and once further additions are considered and adopted by State regulators, the new JOBs Act should be beneficial. There are four key points or segments to the JOBS Act;
Crowdfunding, a novel method of raising capital fueled by the power of social media, became a legal option for small businesses on April 5, 2012 when President Obama signed the Jumpstart Our Business Startups (“JOBS”) Act into law. Among other securities law changes, the JOBS Act allows issuers to raise up to $1 million from a large number of accredited and unaccredited investors by selling securities through a broker or SEC-approved funding portal. When sold through these qualified intermediaries, crowdfunded securities are exempt from the registration requirements of the Securities Act of 1933, as amended (the “Securities Act”), and state securities laws. (Crowdfunding rules have not been completed yet.)
Private Placements (Regulation D)
Among the most significant changes is the elimination of the prohibition on general solicitation. The amendments add new paragraph (c) to Rule 506, which would permit the use of general solicitation in connection with the offer and sale of securities pursuant to the Rule, provided that:
(i) all purchasers of the securities are (or are reasonably believed by the issuer to be) accredited investors;
(ii) the issuer takes “reasonable steps” to verify that such purchasers are accredited investors; and,
(iii) the offering otherwise complies with other applicable provisions of Regulation D, including Rule 501 and Rules 502(a) and 502(d).
The proposal preserves an issuer’s ability to conduct a Rule 506 offering under current paragraph (b) that (1) is not conducted through any general solicitation; and (2) includes sales to no more than 35 non-accredited investors. The proposed amendments to Rule 144A would permit securities sold pursuant to Rule 144A to be offered to persons other than Qualified Institutional Buyer’s (QIBs), including by means of general solicitation, provided that the securities are sold only to persons that the seller and any person acting on behalf of the seller reasonably believe are QIBs.
Verification of Accredited Investor Status
An issuer relying on Rule 506(c) would need to take reasonable steps to verify the accredited investor status of purchasers of its securities. The proposing release describes this process as “an objective determination, based on the particular facts and circumstances of each transaction.” The SEC envisions an issuer considering a number of factors when determining what steps would be reasonable to verify that a purchaser is an accredited investor. The proposing release provides the following examples of such factors, each of which it discusses in some depth:
(i) the nature of the purchaser and the type of accredited investor that the purchaser claims to be;
(ii) the amount and type of information that the issuer has about the purchaser (including reliance on trusted third parties); and,
(iii) the nature of the offering, such as the manner in which the purchaser was solicited to participate in the offering, and the terms of the offering, such as a minimum investment amount.
The draft release notes that the SEC considered but determined not to propose would have required methods of verification. For similar reasons, the SEC has not proposed a non-exclusive list of specified methods for satisfying the verification requirement. The draft release highlights the importance to an issuer of creating and maintaining adequate records that document all efforts to verify accredited investor status. The draft release states the SEC’s intention “to monitor and study the development of verification practices by issuers, securities intermediaries and others as well as the impact of compliance with this requirement on investor protection and capital formation.”
By introducing a new category of publicly-held companies known as an “emerging growth companies”, the bill would exempt businesses with under $1 billion in revenue from certain regulations associated with going public. Notably, companies governed under this category only need to produce two years of audited financial statements when filing for an IPO (normal rules require three years): they are exempted from Dodd-Frank rules giving shareholders a non-binding vote on executive compensation; and are freed from the requirement of hiring an outside auditing firm to check internal financial controls.
I am not convinced that the JOBS Act will make it much easier or less expensive to raise capital, partly because the State and Federal regulators are going to want someone ‘on the hook’ if a deal goes bad or is not transparent enough. Most likely, the liability will rest with the issuers and the crowd-funding platform for the crowd-funding portion of the JOBS Act.
It is unclear whether the regulators are primarily interested in protecting investors or in preserving the current banking complex (FINRA). Either way, the small business community is at a significant disadvantage.
Many of the would-be Equity CrowdFunding platforms that are rapidly populating the Internet are trying to plan around the regulatory delays; others are forging ahead based on the belief they can get away with a work-around to the current regulatory framework now in place. Depending on compensation structure, a would-be crowdfunding platform could participate by carefully following one of our three referenced processes. Any other method would unavoidably create liability for themselves, their clients and even the investors.
Although I am guardedly optimistic that the new rules will help small business and the economy, I do not believe that these changes will be the panacea that many are hoping for. No one wants to trade one current problem for a new one!
Until the new rules are completed and finally adopted, the legality of Equity-based Crowdfunding is not in question. But everyone either has to be compliant under the current regulatory framework or wait for the new rules to be promulgated.
In summary, there are opportunities for Equity-based Crowdfunding, but it is only if you work within the current regulatory framework using one of the 3 options that have been discussed in this paper. The key is to educate one’s self and be sure that you are on sound ground before you accept the first check.
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