SEC Adopts Final Equity Crowdfunding Rules – Will They Be Worth the Wait?
On October 30, 2015, the Securities and Exchange Commission (SEC) adopted, by a vote of 3-1, the much anticipated final rules (Regulation Crowdfunding) permitting equity crowdfunding under Section 4(a)(6) of the Securities Act of 1933 (as amended, the Securities Act), which was added by Title III of the Jumpstart Our Business Startups Act of 2012 (the JOBS Act). Although a set of draft rules was released two years ago (the Proposing Release), it was largely criticized for being too costly and overly-complex for issuers. The SEC received over 485 comment letters on the Proposing Release. The final rules adopted by the SEC represent substantial revisions to the proposed rules as well as several noteworthy additions in response to comments received from the public and the independent considerations of the SEC. The final rules and forms are effective 180 days after publication in the Federal Register except for certain rules relating to funding portal registration (as described more fully below) which are effective on January 26, 2016.
Regulation Crowdfunding is intended to alleviate some of the pent-up demand by so-called “mom and pop” investors by facilitating investments in securities of private companies through crowdfunding intermediaries (i.e. registered broker-dealers or registered funding portals), a concept which had been previously prohibited under federal law. However, the final rules remain complex, and compliance may still be prohibitively costly for many early stage ventures and companies seeking to act as funding portals.
The final rules have important implications for issuers, investors and intermediaries which could dramatically alter the landscape of capital markets for startup companies and early-stage ventures. The below summary provides a brief preliminary overview of some of the most pertinent provisions of Regulation Crowdfunding. We will supplement this alert in the near future with additional alerts providing more detailed analysis of certain aspects of the new rules, including the rules applicable to the registration and operation of funding portals.
Issuers; Limit on Capital Raised
Under the final rules, issuers are permitted to raise up to $1 million in any 12-month period through crowdfunding campaigns using registered broker-dealers or a new class of registrants called “funding portals”. The final rules neither limit the type of securities that may be offered in reliance on Section 4(a)(6) nor prescribe a method for valuing the securities. The SEC did clarify that only capital raised in reliance on the exemption provided by Section 4(a)(6) will be counted toward the $1 million limit. The SEC stated that it believes aggregating the amounts raised in any exemption would be inconsistent with the goal of alleviating the funding gap for startups and small businesses. Therefore, an offering made in reliance on Section 4(a)(6) will not be integrated with another exempt offering made by the issuer provided that each offering complies with the requirements of the applicable exemption that is being relied upon for that offering.
The SEC, however, provided examples that may create some issues for companies trying to engage in concurrent offerings under Securities Act Rule 506 and a crowdfunding offering. For example, an issuer conducting a concurrent offering utilizing general solicitation in reliance on Securities Act Rule 506(c) could not include in any such general solicitation an advertisement of the terms of an offering made in reliance on Section 4(a)(6), unless that advertisement otherwise complies with the more restrictive advertising rules applicable to crowdfunding offerings (as described below). As such, an issuer engaging in such concurrent offerings must be able to conclude that the purchasers in the Regulation Crowdfunding offering were not solicited by means of the general solicitation made in reliance on Rule 506(c).
While the final rules offer a new avenue for raising capital for many startup companies and small businesses, the exemption also contains important restrictions on the types of issuers that qualify for the exemption. For example, ineligible companies include companies not formed in the United States or District of Columbia, issuers that are already subject to the Securities Exchange Act of 1934 (as amended, the Exchange Act), certain investment companies, and other companies lacking a specific business plan or formed solely to engage in a merger or acquisition with an unidentified company.
Given the sensitive nature of the cost of compliance in the current regulatory environment, the final rules provide some concessions to issuers with respect to disclosure requirements as compared to the Proposing Release. However, issuers relying on Regulation Crowdfunding to participate in a crowdfunding campaign must file certain information with the SEC and provide this information to investors and the relevant intermediary facilitating the crowdfunding offering.
The offering documents used by the issuer must include:
- information about officers and directors as well as owners of 20 percent or more of the issuer;
- a description of the issuer’s business and the use of proceeds of the offering;
- the price to the public of the securities and the method of determining the price;
- the target offering amount, the deadline to reach the target offering amount, and whether the issuer will accept investments in excess of the target offering amount;
- certain related party transactions that in the aggregate exceed five percent of the aggregate amount of capital raised by the issuer in reliance on Rule 4(a)(6) during the preceding 12-month period;
- a discussion of the issuer’s financial condition and financial statements of the issuer; and
- a description of the material terms of any indebtedness of the issuer.
The issuer must also disclose its website address and the location on the issuer’s website where investors will be able to find the issuer’s annual report (as well as the date by which such report will be available). The SEC noted that given the internet based nature of crowdfunding, it anticipates that every issuer will have a website or can create one at minimal cost.
The final rules also add a requirement for issuers to disclose any material information necessary in order to make any statements made, in light of the circumstances under which they were made, not misleading. This may prove to be a trap for unsophisticated small businesses in that such businesses may not fully appreciate the legal interpretation or implications of the foregoing and as a result may fail to disclose information that will in hindsight be deemed material, even though not expressly required by the listed categories.
The SEC also modified the rules to require disclosure of the compensation paid to the intermediary so that it can be disclosed either as a dollar amount or percentage of the offering amount or as a good faith estimate if the exact amount is not available at the time of filing. The issuer must also disclose the name, SEC file number and CRD number of the intermediary through which the offering is being conducted and any other direct or indirect interest in the issuer held by the intermediary, or any arrangement for the intermediary to acquire such an interest. As discussed below, in a departure from the Proposing Release, the final rules permit intermediaries to hold such interests in certain circumstances.
Issuers must provide their initial disclosure on Form C and must provide amendments with material changes as well as progress reports (e.g., when the offering is fully funded) and annual filings. In an effort to ease the disclosure burden and help facilitate compliance, issuers may use a “question and answer” format to provide certain disclosures. This Q&A format is a change from the proposed rules and any issuer opting to use this format will prepare an exhibit to its initial filing form.
Notably, in contrast to the Proposing Release, not all issuers will be required to provide audited financial statements – a process that critics argued was too costly and would discourage issuers from pursuing crowdfunding. However, all financial statements must be prepared in accordance with United States Generally Accepted Accounting Principles (U.S. GAAP). Companies raising $100,000 or less need only provide disclosure of the amount of total income, taxable income and total tax as reflected in the issuer’s federal income tax returns certified by the principal executive officer to reflect accurately the information in the issuer’s federal income tax returns and financial statements certified by the principal executive officer to be true and complete in all material respects. If, however, the financial statements of the issuer have been reviewed or audited by a public accountant that is independent of the issuer, the issuer must provide those financial statements in lieu of the foregoing requirement. The SEC acknowledged that if an issuer has not yet filed a tax return and is not required to file a tax return before the end of the offering period, then the tax return information does not need to be provided. Issuers raising between $100,000 to $500,000, or first time crowdfunding issuers offering more than $500,000, are required to provide financial statements reviewed by an independent public accounting firm (unless audited financials are available in which case they must be provided). All other issuers are required to provide financial statements audited by a public accountant that is independent of the issuer.
All issuers will be required to provide a complete set of their financial statements, described as balance sheets, income statements, statements of cash flows and statements of changes in owners’ equity as well as notes to the financial statements. While the SEC acknowledged concerns about the costs for issuers with no operating history or issuers that have been in existence for fewer than 12 months, as well as the costs associated with requiring issuers to follow U.S. GAAP accounting standards, the SEC believes that investor protection will be enhanced by requiring Regulation Crowdfunding issuers to provide financial statements prepared in the same manner as other entities meeting the FASB definition of “public business entity”. Therefore, the final rules do not allow crowdfunding issuers to use less onerous standards available to non-public entities under U.S. GAAP.
The final rules do continue to impose ongoing reporting requirements for issuers. The SEC indicated that this ongoing reporting requirement will benefit investors by enabling them to keep apprised of updated information regarding issuers. The rules require an issuer to file an annual report with the SEC no later than 120 days after the end of the fiscal year covered by the report. The SEC did not go further and require more frequent reporting as suggested by some commenters and decided that an annual requirement was sufficient.
The SEC also adopted the proposed requirement that an issuer post the annual report on its website but did not require physical delivery of the annual report. In adopting this requirement, the SEC did not follow the suggestion of some commenters concerned about protecting an issuer’s commercially sensitive information and sought to have the distribution of annual reports limited to delivery to investors through a password-protected website. The SEC believes that this limitation would add complexity without providing significant protection since the reports will be available on EDGAR. It will be interesting, however, to see if certain issuers are deterred from utilizing equity crowdfunding if they believe that the ongoing reporting requirements will subject them to competitive pressure as a result of premature disclosure of sensitive information.
In a departure from the Proposing Release, the final rules provide for additional grounds for termination of an issuer’s reporting requirements. The proposed rules required issuers to file an annual report until one of the following events occurs: (1) the issuer becomes a reporting company required to file reports under Exchange Act Sections 13(a) or 15(d); (2) the issuer or another party purchases or repurchases all of the securities issued pursuant to Section 4(a)(6), including any payment in full of debt securities or any complete redemption of redeemable securities; or (3) the issuer liquidates or dissolves in accordance with state law. The final rules add the following two additional grounds for termination of ongoing reporting in the event that (1) the issuer has filed at least one annual report and has fewer than 300 holders of record and (2) the issuer has filed at least three annual reports and has assets valued at less than $10 million. Prior to initiating a crowdfunding offering, these milestones are significant for all issuers to evaluate given the cost of the reporting requirements and compliance measures.
Restrictions on Advertising
Issuers are permitted to make limited statements with respect to advertising their offerings pursuant to Rule 204 of Regulation Crowdfunding. These permitted statements are largely consistent with “tombstone ads” under Securities Act Rule 134. Under the final rules, an advertising notice can only include a statement that the issuer is conducting an offering; the name of the intermediary; a link directing investors to the intermediary’s platform; the terms of the offering; and limited factual information about the issuer including the name, address, phone number, website, email address of a representative, and a brief description of the business of the issuer.
Consistent with the recommendations of several commenters on the Proposing Release, the final rules do not limit the methods by which the issuer distributes such notices and statements. In fact, issuers will be permitted to leverage social media to attract potential investors. The SEC made clear that while a notice cannot include more than the enumerated matters, an issuer has flexibility not to include each enumerated matter in the notice. For example, an issuer could simply note on its website or social media that it is conducting an offering and direct potential investors to the offering materials on the intermediary’s platform. The SEC further clarified that no legend would be required on this type of notice because the issuer would be directing investors to the intermediary’s platform which will already include all required legends. The SEC rejected the suggestions of some commenters that all notices be filed with the SEC or the relevant intermediary based on concerns regarding costs of such requirement.
The final rules permit the issuer to communicate with investors about the terms of the offering through communication channels provided by the intermediary on the intermediary’s platform so long as the issuer identifies itself as the issuer in all communications. The SEC acknowledged that it is important for the issuer to be able to respond to questions about the terms of the offering or challenge statements made through the communications channels provided by the intermediary.
It is important to note that the restrictions on advertising and communications apply to persons acting on behalf of the issuer who must identify their affiliation with the issuer in all communications on the intermediary’s platform.
Investors; Investment Limits
The final rules allow “mom and pop” investors, and not just accredited investors, to provide capital through crowdfunding platforms. As expected, investments are capped at certain levels according to the investor’s annual income and net worth. The final rules clarify that all investment limits reflect the aggregate amount an individual investor may invest in all offerings across all issuers in a given 12-month period. Additionally, the final rules provide that each investor’s annual income and net worth are to be calculated according to the same method of calculation used for purposes of determining accredited investor status. Spouses may calculate their net worth and annual income jointly, but if they elect to do so, their aggregate investment may not exceed the limit imposed on an individual investor at the same income and net worth level.
Under the final rules, an investor with annual income or net worth of less than $100,000 is limited to the greater of (1) $2,000 or (2) 5 percent of the lesser of (emphasis added) the investor’s annual income or net worth. An investor with annual income and net worth equal to or in excess of $100,000 is limited to 10 percent of the lesser of (emphasis added) the investor’s annual income or net worth, not to exceed an investment amount of $100,000. For example, an investor with annual income of $30,000 and a net worth of $105,000 would be permitted to invest a total of $2,000. However, an individual with $150,000 in annual income and $100,000 in net worth is capped at $10,000.
The formula provided in the final rules departs from the proposed rules by adopting the “lesser of” approach. The SEC acknowledged that this change could impose constraints on capital formation. Nevertheless, the SEC emphasized that its decision to opt for the “lesser of” standard strikes the appropriate balance between granting issuers access to capital while minimizing investors’ risk exposure and vulnerability to unaffordable losses. The SEC attached great significance to the latter concerns, given the higher failure rate of startups and small businesses likely to take advantage of the crowdfunding exemption. Specifically, households with a substantial gap between net worth and annual income were cited as particularly vulnerable and less able to withstand this risk of loss.
The SEC declined to create different investment limits for accredited or institutional investors or exempt them from the limits altogether, despite a number of comments espousing such a change. The SEC reasoned that the essence of crowdfunding is the ability to seek small individual contributions from a large volume of people and such transactions should be equally available to all types of investors.
The final rules, consistent with the Proposing Release, allow an issuer to rely on efforts that the intermediaries will be required to undertake in order to determine that the aggregate amount of securities purchased by an investor does not cause the investor to exceed the investment limits (provided that the issuer does not have knowledge that the investor has exceeded or would exceed the investment limits as a result of purchasing securities in the issuer’s offering).
Under the final rules, securities purchased in reliance on Section 4(a)(6) will be restricted for one year. However, investors may transfer such securities in limited circumstances. Under Rule 501, securities issued in a transaction pursuant to Section 4(a)(6) may be transferred by the purchaser during that one-year period if transferred to the issuer of the securities; to an accredited investor; as part of an offering registered with the SEC; to a member of the family of the purchaser; to certain trusts; or in connection with the death or divorce of the purchaser or other similar circumstances. The SEC acknowledged that it is not clear how securities purchased through a crowdfunding campaign will be sold in the secondary market. Investors who participate in crowdfunding offerings should be cognizant that they may find that there is not a liquid market for the purchased securities after the restriction period ends.
Securities Act Section 4(a)(6)(C) requires issuers to conduct crowdfunding transactions through SEC-registered intermediaries. Issuers must either use a registered broker-dealer or a registered funding portal and must conduct each offering exclusively through one intermediary platform at a time. As evident based on the discussion below, intermediaries will have to navigate through a regulatory maze in order to comply with Regulation Crowdfunding.
Under the final rules, funding portals are defined as a broker acting as an intermediary in a transaction involving the offer or sale of securities in reliance on Section 4(a)(6) of the Securities Act. Funding portals are not permitted to offer investment advice or recommendations; solicit purchases, sales or offers to buy the securities displayed on its platform; compensate employees or other individuals for solicitation or based on the sale of securities referenced on its portal; or hold, manage, possess or otherwise handle investor funds or securities.
Similar to other regulated entities in the securities industry, funding portals must register with the SEC. The registration process is streamlined by filing Form Funding Portal and will require the funding portal to disclose certain information including, among other things, its principal place of business, form of legal organization, and business activities. The registration will become effective the latter of (1) 30 calendar days after the date the SEC receives the registration or (2) the date the funding portal is approved for membership by a national securities association. Funding portals, like other intermediaries participating in crowdfunding, are required to register with a national securities association. Currently, Financial Industry Regulatory Authority (FINRA) is the only registered national securities association but the SEC recognizes that a new national securities association could register in the future. The SEC received several comments regarding whether to require funding portals to register with FINRA and another national securities association, if and when approved by the SEC in the future. Nonetheless, the SEC declined to adopt this requirement because it would not add significant investor protection given that all registered national securities associations must satisfy the same statutory standard set forth in the Exchange Act.
The SEC acknowledged that crowdfunding intermediaries provide important “gatekeeper” functions to prevent investor fraud. In fact, the SEC dedicated Rule 301 (Measure to Reduce Risk of Fraud) entirely to this topic. As a result, the SEC has shifted at least part of the burden to broker-dealers and funding portals to take meaningful steps to help prevent investor fraud.
Under the final rules, intermediaries must have a reasonable basis for believing that (1) the issuer is in compliance with the applicable rules and regulations and (2) the issuer has established means to keep accurate records of security holders. Intermediaries may rely on the representations of issuers unless the intermediary has a reason to question the reliability of those representations. In addition, an intermediary must deny issuers access to its platform if the intermediary has a reasonable basis to believe that the issuer or any of its officers, directors or certain equity owners are subject to disqualification under Rule 503. At a minimum, an intermediary must conduct background and securities enforcement regulatory history checks on each issuer and the issuer’s officers, directors and beneficial owners of 20 percent or more of the outstanding voting securities. Finally, intermediaries must deny issuers access to its platform if it has a reasonable basis for believing that the issuer or the offering presents the potential for fraud or raises concerns about investor protection.
In addition to preventing investor fraud, intermediaries are required to provide educational materials to prospective investors under the final rules. Specifically, investors are entitled to the following information that must be distributed by the intermediary:
- the process for the offer, purchase, and issuance of securities and the associated risks with purchasing securities offered in reliance of Section 4(a)(6) of the Securities Act;
- the types of securities offered and sold and the associated risks such as having limited voting power;
- the resale restrictions;
- information that the issuer is required to provide under Rule 202 (Ongoing Reporting Requirements) and the fact that such obligations may terminate in the future;
- applicable investment limits;
- the limitations and circumstances regarding the investor’s right to cancel an investment commitment;
- the appropriateness of such investor investing in a crowdfunding campaign;
- the future relationship between the issuer and the intermediary; and
- the circumstances in which the issuer may cease to publish annual reports and current financial information about the issuer.
Moreover, under the final rules, intermediaries are required to provide on their platform the most current version of their investor education information.
Financial Interests; Compensation
The final rules prohibit directors, officers or partners of an intermediary, or any person performing similar functions, from having (or receiving as compensation as a result of the offering) a financial interest in an issuer selling securities through the intermediary’s platform. The final rules do, however, permit an intermediary to have a financial interest in the issuer if the intermediary (1) receives the financial interest from the issuer as compensation for the services provided and (2) the financial interest consists of securities of the same class and having the same terms, conditions and rights as those being offered through the intermediary’s platform.
The SEC provided a plethora of other rules regulating intermediaries on items such as accounts and electronic delivery (Rule 302(a)), requirements with respect to transactions (Rule 303), completion of offerings, cancellations and reconfirmations (Rule 304), payments to third parties (Rule 305) and certain rules specifically regulating funding portals. In addition, non-U.S. based funding portals, known as nonresident funding portals, are subject to an additional regulatory framework pursuant to Rule 400(f). Prior to becoming an intermediary for crowdfunding campaigns, a full analysis of the compliance costs and ongoing compliance framework should be completed by the broker-dealer or funding portal.
The SEC anticipates that the crowdfunding provisions of the JOBS Act will provide a boost to startup companies and small businesses in raising modest sums of capital while allowing investors to partake in a wider range of securities offerings than perhaps ever before. Nonetheless, the SEC acknowledged that the new regulatory regime poses certain likely costs and challenges to efficiency, competition, and capital formation. Although we are hopeful that the final rules provide a new avenue to connect issuers and investors to create more efficient capital markets for startup companies and small businesses in the near future, it remains to be seen whether the hurdles presented will be too great to allow for creation of an active crowdfunding marketplace. As noted by Commissioner Michael S. Piwowar in his dissenting statement at the Open Meeting on Crowdfunding and Small Business Capital Formation, the rules include “many traps for the unwary” that may unduly chill the use of equity crowdfunding by small businesses.
For additional information or questions, please contact Lori Smith (212.714.3075; firstname.lastname@example.org), Ryan Udell (215.864.7152; email@example.com), or Michael Psathas (212-868-4833; firstname.lastname@example.org).
 Pub. L. No. 112-106, 126 Stat. 306 (2012).
 See Rel. No. 33-9470 (October 23, 2013) available at http://www.sec.gov/rules/proposed/2013/33-9470.pdf.
 See Rule 100(a) of Regulation Crowdfunding.
 Rel. No. 33-9974 at 18.
 See Id.
 See Id. at 19.
 See Rule 100(b) of Regulation Crowdfunding.
 See Rule 201 of Regulation Crowdfunding.
 Rule 201(a), (w) of Regulation Crowdfunding.
 See Rel. No. 33-9974 (October 30, 2015) at 48.
 See Rule 201(y) of Regulation Crowdfunding.
 See Rule 201(o)(1) of Regulation Crowdfunding.
 Rule 201(n), (o)(2) of Regulation Crowdfunding.
 Rule 203(a) of Regulation Crowdfunding.
 See Rule 201(t)(1) of Regulation Crowdfunding.
 See Id.
 See Instruction 6 to Rule 201(t) of Regulation Crowdfunding.
 See Rule 201(t)(2), (3) of Regulation Crowdfunding.
 See Rule 201(t)(3) of Regulation Crowdfunding.
 Instruction 3 to Rule 201(t) of Regulation Crowdfunding.
 Rel. No. 33-9974 at 102–03, 421–22.
 See Id. at 121.
 See Rule 202(a) of Regulation Crowdfunding.
 See Rel. No. 33-9974 at 123.
 Rule 202(b) of Regulation Crowdfunding.
 See Rule 202(b)(2), (3) of Regulation Crowdfunding.
 Rule 204(b) of Regulation Crowdfunding.
 See Rel. No. 33-9974 at 142.
 Rule 204(c) of Regulation Crowdfunding.
 See Rel. No. 33-9974 at 143.
 See Rule 204(c) of Regulation Crowdfunding.
 Generally, the definition of “Accredited Investor” includes (1) any person whose individual net worth, or joint net worth with that person’s spouse, exceeds $1,000,000, (excluding the value the person’s primary residence) and (2) any person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with such person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year. 17 CFR § 230.501.
 Rule 100(a)(2) of Regulation Crowdfunding.
 Instruction 1 to Rule 100(a)(2) of Regulation Crowdfunding.
 See Instruction 2 to Rule 100(a)(2) of Regulation Crowdfunding.
 Rule 100(a)(2)(i) of Regulation Crowdfunding.
 Rule 100(a)(2)(ii) of Regulation Crowdfunding.
 See Rel. No. 33-9974 at 26.
 See Id. at 27.
 See Id. at 28.
 See Instruction 3 to Rule 100(a)(2) of Regulation Crowdfunding.
 Rule 501 of Regulation Crowdfunding.
 Rule 501(a) of Regulation Crowdfunding.
 See Rule 300(c)(2) of Regulation Crowdfunding.
 See Id.
 See Rule 400 of Regulation Crowdfunding.
 Rule 400(a) of Regulation Crowdfunding.
 Rule 300(a)(2) of Regulation Crowdfunding.
 Rule 301(a) and (b) of Regulation Crowdfunding.
 Rule 301(c)(1) of Regulation Crowdfunding.
 Rule 301(c)(2) of Regulation Crowdfunding.
 Rule 302(b)(1) of Regulation Crowdfunding.
 See Rule 300(b) of Regulation Crowdfunding.