An Overview by Elesa A. Rectanus, Associate, Sloane & Johnson, PLLC

Transcription

1 B. CROWDFUNDING RULES An Overview by Elesa A. Rectanus, Associate, Sloane & Johnson, PLLC On October 30, 2015 the Securities and Exchange Commission (the SEC ) adopted the final rules, Regulation Crowdfunding, under the Securities Act of 1933 (the Securities Act ) and the Exchange Act of 1934 (the Exchange Act ) to implement Title III of the Jumpstart Our Business Startups ( JOBS ) Act. Title III of the JOBS Act created a new exemption from registration for crowdfunding offerings, Section 4(a)(6) of the Securities Act. Regulation Crowdfunding enables individuals to participate in securities-based crowdfunding transactions pursuant to Section 4(a)(6) of the Securities Act, provided that certain requirements are met by each of the investors, issuer and intermediary participating in the crowdfunding transaction. The impetus behind crowdfunding is to remove the traditional barriers to capital that many small businesses face by providing small businesses with access to the general public through the internet for the purpose of raising capital. The final rules reflect relatively minor modifications to the proposed rules, which were released on October 23, The final rules will be effective as of May 16, GENERAL REQUIREMENTS Limitation on Capital Raised An issuer may raise up to an aggregate amount of $1 million from a large number of investors (the crowd ) within any rolling 12-month period in reliance on Regulation Crowdfunding. When determining whether an issuer is within the limitation, the issuer must calculate the amounts sold by the issuer in addition to any amounts sold by any predecessor of the issuer and any entities controlled by or under common control with the issuer. Investor Limitations Some of the more notable modifications from the proposed rules appear in connection with the investor limitations. The final rules clarify that the investment limit is an aggregate investment limit, such that the investment limit reflects all investments made by an investor in all crowdfunding offerings in which such investor participated over the course of a 12-month period, and not a single crowdfunding offering. In addition, the SEC modified the investment limit calculation in order to provide additional investor protections. The SEC specifically focused on those investors who may be less able to bear the risk of loss, as the SEC anticipates startups and small businesses, which have an increased likelihood of failure as compared to growth companies, to rely most heavily on the crowdfunding exemption. There are two numerical investor limitations. The first is an aggregate investment limit of $100,000 for all crowdfunding offerings during a 12-month period. The second is within the $100,000 limit and employs a lesser of approach that is based on the annual income or net worth of the investor. An investor s investment limit is calculated as follows: (i) If either annual income or net worth of an investor is less than $100,000, then the investor may invest up to the greater of (x) $2,000 or (y) 5% of the lesser of the investor s annual income or net worth; or

2 (ii) If both annual income and net worth of an investor are equal to or greater than $100,000, then the investor may invest up to 10% of the lesser of the investor s annual income or net worth. For instance, investor X has annual income of $50,000 and a net worth of $105,000. Because X s annual income is less than $100,000, X may invest up to the greater of $2,000 or 5% of $50,000 ($2,500). X s investment limit is equal to $2,500, such that X may invest no more than an aggregate amount of $2,500 in all crowdfunding offerings during the course of a 12-month period. Despite the more restrictive investment limits implemented by the final rules as opposed to the proposed rules, the final rules permit an investor to calculate income and net worth jointly with the investor s spouse. Non-Eligible Issuers An issuer may not be one of the following companies, among others as determined by the SEC, in order to utilize the crowdfunding exemption: Foreign companies; Reporting companies; Investment companies, including hedge funds; Bad actors that are disqualified from participating in the crowdfunding offering due to certain securities law or fraud-related violations; Companies that sold securities pursuant to the crowdfunding exemption but failed to file annual reports with the SEC, and to provide such reports to investors, during the two years immediately preceding the filing of the new offering statement (see below description of reporting requirements for companies engaged in a crowd funding offering); and Blank check companies. Transactions Conducted through an Intermediary An intermediary may be either a registered broker-dealer or a registered funding portal. In order to conduct a crowdfunding offering in reliance on Section 4(a)(6), an issuer may do so solely through the use of only one intermediary, and such offering must be conducted exclusively through such intermediary s platform. A platform is defined under Regulation Crowdfunding as a program or application accessible via the Internet or other similar electronic communication medium through which a registered broker or a registered funding portal acts as an intermediary in a transaction involving the offer or sale of securities in reliance on Section 4(a)(6). Aggregation and Integration There is no aggregation or integration with other exempt offerings. The $1 million limitation only applies to the capital raised by an issuer pursuant to the crowdfunding exemption. Similarly, there is no integration with other exempt offerings. An issuer may engage in a Section 4(a)(6) offering while another exempt offering is occurring simultaneously, has occurred prior to or occurs after the Section 4(a)(6) offering. However, each exempt offering must satisfy the requirements of the exemption being relied upon. For instance, if an issuer is conducting a crowdfunding offering while simultaneously

3 conducting an exempt offering that does not permit general solicitation, the issuer must determine that the purchasers in the other exempt offering were not solicited by means of the crowdfunding offering. Resale Limitations The final rules prohibit the resale of securities issued pursuant to the crowdfunding exemption for one year after the date of purchase, except when transferred to the issuer, an accredited investor, piggybacking on a registered offering, or to a family member of the purchaser. ISSUER OBLIGATIONS Disclosure Requirements An issuer engaged in a crowdfunding offering in reliance on Section 4(a)(6) must provide specific disclosures to each of the SEC, investors and the relevant intermediary. The issuer must file these required disclosures with the SEC on the new Form C. Offering Statement Disclosure Requirements: Information About the Issuer and the Offering An issuer must disclose the following: Officers and Directors. General information about its officers and directors, such as the period of time that the directors and officers served in their respective positions, and their business experience for the past three years. Use of Proceeds. A description of the purpose of the offering and the definitive plans or the range of possible uses for the proceeds. Offering Price. The price of the securities being offered or the method to determine the price, as the offering price is not required to be a fixed price. Types of Securities Offered and Valuation. The final rules do not limit the types of securities, whether it be equity or debt, that may be offered in a crowdfunding offering, nor prescribed a valuation method for securities. Target Offering Amount and Deadline. The target offering amount and the deadline to achieve the target offering amount. A description of the process to cancel an investment commitment, and upon achieving the target amount, to complete the transaction. An issuer must disclose in connection with a description of the subscription process that: (i) the investors have an unconditional right to cancel for any reason until 48 hours before the deadline; (ii) the investors will receive notification from the intermediary that the target amount has been met; (iii) the issuer can close the offering prior to the deadline upon achievement of the target amount (provided the offering has not been open for less than 21 days); provided, however, that if the offering closes early, each investor must have received notification of the new offering deadline no less than five business days before the new deadline. If the investor decides not to cancel, upon the closing of the offering the issuer will receive the funds and the investor will receive securities.

4 In the event of a material change to the offering, and if the investor does not reconfirm the investor s commitment, the investor s commitment will be cancelled and the issuer will return the committed funds. If the target offering amount is not achieved by the deadline, then no securities will be sold, all commitments will be cancelled and all committed funds will be returned to investors. Oversubscription. An issuer s ability to accept investments in excess of the target amount is only limited by the $1 million annual aggregate limitation. An issuer must disclose whether it will accept investments in excess of the target amount. At the commencement of the offering, an issuer must provide a description of the purpose, method for allocating oversubscriptions and intended use of such excess proceeds. Ownership and Capital Structure. An issuer is required to identify the beneficial owners of 20% or more of the issuer s total outstanding voting securities, as well as provide a description, which includes the number of securities being offered and those outstanding, whether such securities have voting rights and any limitations on such voting rights, and the restrictions on the transfer of securities. Additional Required Disclosures. An issuer is required to provide additional disclosures including: the intermediary s name, SEC file number, and CRD number; amount of compensation paid to the intermediary for conducting the offering, including the amount of any referral or other fees associated with the offering; the total number of the issuer s employees; legends; material risk factors relevant to the issuer, which are similar to risk factors in a prospectus; material terms of the issuer s indebtedness; any exempt offerings conducted within the past three years; and certain related-party transactions. Offering Statement Disclosure Requirements: Financial Disclosure In addition to the above disclosures, an issuer is required to file with the SEC and provide to investors and the relevant intermediary a complete set of its financial statements, which includes a balance sheet, income statement, statement of cash flows and statement of changes in owners equity, prepared in accordance with U.S. generally accepted accounting principles covering the shorter of the two most recently completed fiscal years or the period since inception of its business. The financial disclosure requirements applicable to an issuer depend on the amount offered and sold within a 12-month period. The scaled financial disclosure requirement is as follows: An issuer offering $100,000 or less of securities in reliance on Regulation Crowdfunding is required to provide certain information provided on the issuer s federal tax return for the most recently completed fiscal year, in addition to the above-described financial statements, all of which must be certified by the principal executive officer. An issuer offering greater than $100,000 but no greater than $500,000 is required to provide financial statements reviewed by an independent public accountant. An issuer offering greater than $500,000 (but subject to the $1 million cap) is required to provide audited financial statements, except that a first-time issuer is only required to provide financial statements reviewed by an independent public accountant. Progress Updates

5 Upon achievement of the target offering amount, an issuer must file with the SEC Form C-U to report the total amount of securities sold in the offering. Progress updates must be made available to investors by the intermediary or the issuer no later than five business days after achievement of each of the following targets: 50% of the target amount, 100% of the target amount, and acceptance of subscriptions in excess of the target amount. Amendments to the Offering Statement An issuer required to amend its offering statement disclosures if there is any material change in the offer terms or disclosure previously provided to investors. Annual Reporting Requirement An issuer who sells securities in reliance on Section 4(a)(6) must file an annual report with the SEC no later than 120 days after the end of its most recent fiscal year. In addition, an issuer must post its annual report on its website sells, and is not required to provide to investors copies of the annual report, physical or digital, or refer to the posting via . The annual report is required to include disclosures that are similar to the disclosures required in the offering statement. The requirement to file an annual report terminates upon the earliest to occur of: (i) (ii) (iii) (iv) (v) the issuer becoming a reporting company; the purchase or repurchase by the issuer or another party of all of the securities issued pursuant to the crowdfunding exemption, including any payment in full of debt securities or any complete redemption of redeemable securities; the issuer has filed at least one annual report and has fewer than 300 holders of record; the issuer has filed at least three annual reports and has total assets that do not exceed $10 million; or liquidation or dissolution of the issuer s business. Limitations on Advertising the Offering Terms An issuer can advertise an offering in reliance on Section 4(a)(6) solely by publishing notices of the offering terms, which are similar to tombstone ads. The advertising notice may only include the following information: a statement that the issuer is conducting an offering, the intermediary s name and a link to the intermediary s platform; the offering terms, which includes the amount, nature, and price of the securities offered and the closing date of the offering period; and certain factual information about the issuer and a brief description of its business. The final rules do not restrict an issuer from engaging in communications if there is no reference to the offering terms, except as permitted in an offering notice, and such communication pertains to factual business information. Additionally, an issuer may communicate with investors about the offering terms through the intermediary s platform, provided that the issuer identifies itself as the issuer in all communications. Compensation of Persons Promoting the Offering Under Rule 205 of Regulation Crowdfunding, an issuer is prohibited from directly or indirectly compensating any person for promoting the offering through the intermediary s platform unless the

6 issuer takes reasonable steps to ensure that the person clearly discloses that it receives compensation for such promotion each time such person posts promotional material on the platform. This requirement applies broadly to all persons acting on behalf of the issuer, including any person specifically hired to promote the offering or a founder or employee of the issuer that engages in promotional activities through the platform, regardless of whether the person is compensated for promotional activities. INTERMEDIARY OBLIGATIONS General Requirements of Intermediaries An offering in reliance on Section 4(a)(6) requires an offering to be conducted through an intermediary. An intermediary is either a registered broker-dealer or a funding portal, which is a new type of online investment service provider and which is registered with the SEC and any applicable self-regulatory organization ( SRO ), such as FINRA. Rule 300(b) prohibits an intermediary s directors, officers or partners from having any financial interest (meaning a direct or indirect ownership of, or economic interest in, any of the issuer s securities) in an issuer using its services, and prohibits such persons from receiving a financial interest in an issuer as compensation for its services in connection with the offering. However, an intermediary itself may have a financial interest in an issuer using its services as long as: (i) the intermediary receives the financial interest from the issuer as compensation for the services provided in connection with the offering; and (ii) the financial interest consists of securities of the same class and having the same terms, conditions and rights as those sold in the offering. Measures to Reduce the Risk of Fraud An intermediary must have a reasonable basis for believing that an issuer has (i) complied with the statutory issuer requirements and all relevant requirements of Regulation Crowdfunding; and (ii) established means to keep accurate records of holders of the securities offered and sold through the platform; provided, that if an issuer engages a registered transfer agent, an intermediary will be deemed to have satisfied the recordkeeping requirement described in item (ii) above. In satisfying either of the above requirements, an intermediary can reasonably rely on an issuer s representations that it is in compliance and keeps accurate records unless the intermediary has reason to question the reliability of such representations. As a modification to the proposed rules, the final rules also apply the reasonable belief standard to intermediary requirement to deny access to its platform. Specifically, an intermediary must deny access to its platform if it has a reasonable belief that an issuer or the offering presents the potential for fraud or raises investor protection concerns, or that it is unable to adequately assess such risk of fraud. An intermediary must deny an issuer access to its platform if the intermediary has a reasonable basis for believing that an issuer or any of its directors, officers or beneficial owners of 20% or more is subject to disqualification under Rule 503. An intermediary must conduct background and securities enforcement regulatory history checks on each issuer listing securities on its platform and on each director, officer and 20% beneficial owners. Account Openings

7 Rule 302 prohibits an intermediary from accepting an investment commitment until the investor opens an account with the intermediary and consents to electronic delivery. Upon the opening of an account, the intermediary must provide educational materials to the investor. Education Materials. The educational materials, which are in in plain language, must discuss the following: the offering process, the risks associated with a crowdfunding offering and whether such offering is appropriate for the investor; the types of securities that may be offered through its platform and the risks associated with each type, including the risk of limited voting power due to dilution; resale limitations; required issuer disclosures; individual investment limits; and that the intermediary may not continue to have a relationship with the issuer after completion of the offering. An intermediary is required to maintain accurate educational materials. Upon any material revisions to the educational materials, such revised materials must be made available to all investors before accepting any additional investment commitments or effecting any further crowdfunding transactions. Promoters. An intermediary must inform investors, upon opening an account, that any person that engages in promotional activities on the issuer s behalf on the intermediary s platform, whether such person is compensated for such promotions or is a founder or employee of the issuer, must clearly disclose in all platform communications the receipt of the compensation and the fact that the person is engaging in promotional activities on the issuer s behalf. Compensation Disclosure. Separately, an intermediary must disclose, when opening an account, the manner in which it will be compensated in connection with crowdfunding offerings. Transaction Obligations Issuer Information. No later than 21 days before the first sale of securities, an intermediary must make available to the SEC and potential investors any information the issuer must provide under Rules 201 (issuer disclosure requirements) and 203(a) (Form C disclosures). The intermediary must make such information publically available on its platform, and maintain the public availability of this information and any additional issuer information until the completion or termination of the offering. An intermediary cannot require a person to establish an account with the intermediary in order to access this information. Investor Verification. An intermediary must ensure investors know and comply with the investor limitations. An intermediary can rely on investor self-certification of investor limitations, but it must have a reasonable basis for believing the investor satisfies the investor limitations under Section 4(a)(6)(B) before allowing an investor to make an investment commitment. Acknowledgement of Risk. Prior to accepting each investment commitment from an investor, an intermediary must obtain from the investor a representation and a completed questionnaire to ensure the investor acknowledges the risks of the investment. Communication Channels. An intermediary must provide on its platform means through which investors are able to communicate with other investors and the issuer s representatives. These communications must be publically available on its platform; however, only those who have accounts with the intermediary can post comments. Moreover, any person who posts a comment must disclose whether such person is a founder or employee engaging in promotional activities on behalf of the issuer, or

8 otherwise is compensated for such promotion. Funding portals cannot participate in these communications except to establish guidelines and remove abusive or potentially fraudulent communications. Notice of Investment Commitment. Upon receipt of an investment commitment from an investor, the intermediary must provide such investor with a notice that includes the investment terms and a reminder of the investor s right to cancel. Maintenance and Transmission of Funds. Rule 301(e)(1) implements Section 4A(a)(7), which requires an intermediary to ensure that all offering proceeds are only provided to the issuer when the target offering amount is met or exceeded. Rule 301(e)(1) also requires that a registered broker comply with the established requirements of Rule 15c2-4 of the Exchange Act for the maintenance and transmission of investor funds. Because funding portals cannot manage, possess or handle funds or securities, a funding portal is required to use a qualified third party (a registered broker-dealer, bank, or credit union) to handle investor funds and must direct investors to transmit the funds directly to a qualified third party. Confirmation of Transaction. At or before the completion of a crowdfunding transaction, an intermediary is required to provide to each investor a notification disclosing: the transaction date; the type, identity, price and number of securities purchased and the overall number and price of securities sold by the issuer in the transaction; certain specified terms of the security (such as debt or callable security); and the source and total amount of any remuneration that the intermediary will receive in connection with the transaction, whether from the issuer or other persons. Notice of Cancellation & Reconfirmation In the event an offering closes early, the offering terminates, or a material change to the terms occur, the intermediary must provide investors with notice regarding the right to cancel or the need to reconfirm commitments, each of which must be done by the investor within five business days of the investor s receipt of the notice. Upon the termination of an offering, the intermediary must provide to investors, within five business days of termination, notice of the cancellation and the refund amount. Third Party Payments An intermediary can compensate a third party for directing potential investors or issuers to the intermediary s platform via general business advertising. However, in no instance may an intermediary compensate a third party for providing the intermediary with any investor s personally identifiable information. Obligations Specific to Funding Portals Exemption from Broker-Dealer Registration. Without an exemption or exception from registration, a funding portal would fall within the definition of a broker under Section 3(a)(4) of the Exchange Act and be subject to the rules and regulations governing brokers. Rule 401 provides registered funding portals with an exemption from broker registration requirements under Exchange Act Section 15(a)(1). Funding portals are required to register with the SEC via Form Funding Portal, which requires information similar to, albeit less burdensome than, Form BD. The tradeoff for less regulation is the limitation of a funding portal s activities.

9 A funding portal is prohibited from performing any of the following activities: offering investment advice or recommendations; soliciting purchases, sales or offers to buy securities offered or displayed on its platform; compensating promoters or other persons for solicitations based on the sale of securities displayed or referenced on its platform; or holding, managing, possessing, or handling investor funds or securities. Conditional Safe Harbor. However, Regulation Crowdfunding identifies certain limited activities that a funding portal may engage in without violating the statutory prohibitions described above. Due to the evolving nature of crowdfunding, the SEC intended the below activities, which compose the safe harbor, to be non-exclusive. A funding portal may engage in the following: Limit the issuers and offerings allowed on a funding portal s platform Highlight issuers and the offerings of certain issuers on a funding portal s platform Provide search functions on and communication channels through its platform Advise issuers as to the structure or content of the issuer s offering Compensate third parties for referrals, provided it does not receive personally identifiable information and such compensation is not transaction-based Enter into written compensation arrangements with brokers whereby funding portals may compensate or receive compensation from brokers, including transaction-based compensation Advertise its services and certain issuers or offerings available through its platform Accept investor commitments on behalf of issuers using its platform (although it may not handle investor funds, as discussed above) Compliance Requirements. The recordkeeping requirement, which is similar to broker recordkeeping requirements, imposed on a funding portal requires, among others things, the maintenance of certain records for five years and that such records are easily accessible for at least the first two years, and the creation and maintenance of daily, monthly and quarterly summaries of the transactions on its platform. A funding portal is required to comply with the same privacy rules as brokers, and implement written policies and procedures reasonably designed to achieve compliance with the federal securities laws and regulations. Moreover, a funding portal is subject to the examination and inspection authority of the SEC. MISCELLANEOUS PROVISIONS Insignificant Deviations Regulation Crowdfunding affords issuers a safe harbor, Rule 502(a), for insignificant deviations from the requirements of Regulation Crowdfunding. Exemption from Section 12(g) Regulation Crowdfunding exempts holders of securities issued pursuant to a crowdfunding offering from inclusion in the record holder threshold of Section 12(g) of the Exchange Act, provided that the issuer is in compliance with the annual report requirement under Regulation Crowdfunding, has less than $25 million in total assets as of the end of its last fiscal year and engages the services of a registered transfer agent.

10 Statutory Liability While the statutory liability provision of Section 4A(c) of the Securities Act applies only to an issuer, the definition of an issuer is such that an intermediary would likely fall within the definition of an issuer with regard to the statutory liability provision of Section 4A(c). The SEC expressly declined to exempt intermediaries from the definition of an issuer under Section 4A(c), which results in the likely application of Section 4A(c) to intermediaries. Disqualification The bad actor disqualification rules provided in Rule 503 are similar to the Rule 506 disqualification rules as they relate to the issuer and certain associated persons. CONCLUSION Regulation Crowdfunding affords another opportunity for investors to participate in crowdfunding transactions. While Regulation A+ and Rule 506(c) enable individuals who qualify as accredited investors to participate in crowdfunding transactions, Regulation Crowdfunding expands the availability to participate in crowdfunding transactions across individuals regardless of net worth or annual income, as there is no investor qualification requirement. Despite the broad application, the monetary ceiling of $1 million may prove to be disproportionate in light of the costs and potential liability associated with pursuing a crowdfunding offering under Regulation Crowdfunding. Whether startups and small companies will employ Regulation Crowdfunding as opposed to other exemptions such as Regulation A+ is up for debate.