As part of the JOBS Act of 2012, Congress passed the Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act (or “Crowdfund Act”). But it won’t be available until the SEC promulgates rules making the provisions operational and clarifying what some of the legislative language means in practice. Here is what we know to date about how crowdfunding will work for issuers (it also has requirements for the so-called “funding portals”, which we won’t discuss today):
Issuer Volume Limitation. The total amount of securities an issuer may sell to all investors during the 12-month period immediately preceding the crowfunding transaction, including those securities sold in the crowdfunding transaction, may not exceed $1 million.
Investor Volume Limitation. The total amount of securities an issuer may sell to any individual investor purchasing securities in a crowdfunding transaction in any 12-month period, including both the crowdfunding transaction and all other transactions during the period is:
- The greater of $2,000 or 5% of annual income or net worth, if the annual income or net worth of the investor is less than $100,000; or
- 10% of annual income or net worth, up to a maximum of $100,000, if the annual income or net worth of the investor is greater than $100,000.
Required Funding Portals. Crowdfunding transactions must be conducted through a broker or a “funding portal” that has registered with the SEC. The portals will have significant responsibility for preventing issuer fraud and for protecting investors. These responsibilities include educating and screening potential investors, taking appropriate action to reduce the risk of fraudulent transactions (including checking the background of the issuer and its insiders), providing disclosure to the SEC, ensuring that the issuer does not receive any funding until the target offering amount has been raised, and taking steps to ensure that investors do not purchase more than their annual limit of securities of the issuer.
Advertising. Issuers may only use advertisements that direct potential investors to the broker or funding portal. In effect, issuers in crowdfunding transactions will have much greater latitude to sell securities to strangers than they do in traditional private placements, which prohibit “general solicitation” of investors. Of course, the JOBS Act also called for the SEC to introduce a rule to eliminate the ban on advertising and general solicitation in Regulation D — Rule 506 transactions where all investors are accredited. This is by far the most exciting feature of the JOBS Act in the area of private placements. But it also has the potential for rampant fraud.
Target Offering Size. Issuers must disclose the amount of money they intend to raise. Investors will be able to rescind their commitments if the issuer does not reach this target.
Exchange Act Relief. The Crowdfund Act provides that the investors who join the issuer pursuant to the exemption will not count toward the reporting company shareholder threshold. In the absence of this relief, crowdfunded companies could easily end up with so many shareholders (now 2,000 accredited investors or 500 non-accredited investors) that they would be subject to public company reporting requirements.
Blue Sky Relief. Securities sold in crowdfunding transactions will be exempt from the substantive registration and qualification requirements of state securities or “blue sky” laws, just as Rule 506 securities are now.
Restrictions on Transfer. Like other privately placed securities, securities sold in crowdfunding transactions will not be immediately freely transferrable. Subject to limited exceptions, crowdfunding securities must generally be held for one year before they can be transferred without restriction.
Issuer Disclosure Requirements. Unlike under Rule 506, the Crowdfund Act does require issuers provide substantial disclosure to potential investors and ongoing financial disclosure on at least an annual basis. The information that must be disclosed includes:
- the issuer’s directors, officers, and each person holding more than 20% of its shares;
- the issuer’s business plan;
- financial information, depending on the size of the offering:
- offerings under $100,000 – income tax returns and financial statements certified by the issuer’s principal executive officer;
- offerings over $100,000 but under $500,000 – financial statements reviewed by an independent public accountant; and
- offerings over $500,000 – audited financial statements;
- use of proceeds and target offering amount; and
- information about the offered securities and the issuer’s other securities, including disclosure about the rights of crowdfunding investors relative to the issuer’s other investors.
As you will have gathered by now, crowdfunding transactions will require both the advice of lawyers and accountants. But the start-up community had hoped for a way of raising money that would avoid complex legal and financial compliance and regulation. Well they did not get what they wanted, and chances are that once the SEC rules are promulgated, the process will be even more arcane and less straight-forward.
I invite your comments to this blog post and look forward to posting another missive in the near future.
John A. Myer is a corporate and securities lawyer with Myer Law PLLC in Seattle, Washington. This posting does not constitute legal advice.