By Cydney Posner
This morning, the SEC voted unanimously to propose rules and forms related to the offer and sale of securities through crowdfunding under Section 4(a)(6) of the Securities Act, as mandated by the JOBS Act. Crowdfunding has been used to share views about and raise funds for various purposes for a number of years but, historically only through donation or in exchange for items of token value. Now, as directed by Congress, the SEC is proposing to allow securities-based crowdfunding that would be exempt from registration under Section 5 of the Securities Act, subject to a number of prescribed conditions, including the required use of registered intermediaries, either brokers or funding portals that will be subject to SEC and SRO oversight.
The proposed new rules, Regulation Crowdfunding – a title that just trips off the tongue -- will implement what is essentially a new regulatory regime. As such, it was particularly challenging for the SEC to develop, keeping in mind the need to balance the objective of facilitating capital formation while protecting investors from fraud. The SEC staff has been directed to develop a "comprehensive work plan" to monitor the use of the crowdfunding exemption. The proposed rules require the following:
- Maximum amount that can be raised through crowdfunding of $1 million annually;
- Investor limitations, based on greater of income or net worth tests, on amount that can be invested;
- Issuer disclosure, filed with the SEC, regarding the business and its management, directors and certain stockholders, terms of the offering, use of proceeds, related-person transactions and other matters;
- Disclosure of tax returns and filing of financial statements using U.S. GAAP, covering the shorter of the two most recent fiscal years or the period since inception: if the company is raising less than $100,00, they may be certified by the CFO; if more than $100,000 but less than $500,000, an independent accountant review is required; and if more than $500,000, an audit is required;
- Filing of an annual report with basically the same information as above, except for the specific offering information, which will continue until the company is a an Exchange Act reporting company, repurchases all the securities or liquidates; and
- Securities will be subject to resale restrictions of one year.
Investors will be permanently exempt from the 12(g) count of record holders.
There are "bad actor" disqualification provisions, substantially similar to the bad actor rules for Reg D, to bar certain companies from using the exemption. In addition, certain companies would be ineligible to use the new exemption, including reporting companies, foreign issuers, investment companies, companies that have not complied with the requirements of the crowdfunding rules, blank-check companies and SPACs. There are also safe harbors available for companies for insignificant deviations from the rules and for intermediaries for some activities that could otherwise be viewed as prohibited.
To provide gatekeeper safeguards and ensure that information can be shared appropriately, all crowdfunding offerings must take place using registered intermediaries, such as brokers or funding portals. Intermediaries will be required to provide educational materials regarding crowdfunding risks, make available on their platforms company information, take steps to ensure the proper transfer of investor funds and issuer securities, obtain information regarding investor net worth and income and other crowdfunding investments, comply with anti-money-laundering and privacy rules, refrain from having any financial interest in the company, giving investment advice or handling customer funds or securities. Intermediaries must have a reasonable basis to believe that the issuer has complied with the crowdfunding requirements and conduct background checks on the company, its officers, directors and major stockholders. Intermediaries will be limited in their securities activities to acting as crowdfunding portals and must register with the SEC and FINRA or another national securities association. It is expected that FINRA will also shortly be issuing rules for portals.
While all the commissioners supported release of the proposal –"unleashing the wisdom of the crowd" and "the proof is in the pudding" were some of the phrases most commonly trotted out -- there was clearly a difference in degree of reservation about the potential risks involved. Commissioners Gallagher and Piwowar welcomed the proposal wholeheartedly, in effect wondering what had taken so long. Commissioner Piwowar noted that there are significant differences in the availability of information about a company that an individual could obtain in 1933 as compared with the ease of obtaining information now by simply booting up a computer. In addition, he noted, the internet allows persons to collectively express their opinions about any number of subjects, including companies.
Commissioners Aguilar and Stein expressed greater concerns about the risks involved. Commissioner Aguilar noted that these types of securities were generally illiquid and at high risk for fraud, self-dealing and overreaching by companies. He was particularly concerned about the potential for "affinity frauds" that target the most vulnerable groups and urged that Enforcement and state regulators monitor use of the exemption carefully. Commissioner Stein observed, somewhat ironically, that the "central challenge" of creating and overseeing the new crowdfunding marketplace is that "the main objective is to gain access to capital from retail investors, who are precisely the individuals who our securities laws are designed to most protect." She specifically requested public comment on three areas: whether the investor limitation (which is ambiguous in the statute) based on the net worth/income tests should apply based on the "greater of" these two tests (as proposed) or the lesser of the tests, whether non-U.S. portals should be permitted to register and operate in the U.S. (taking into account concerns regarding jurisdiction and enforcement), and whether there may be third-party solutions that are less costly than transfer agents to help companies carry out their responsibilities to maintain accurate stockholder records. Finally, she noted that a prior SEC experiment to liberalize the restrictions on small offerings in Rule 504 failed because of "pervasive fraud," which underlined the importance of getting the balance right this time.