April 2012
With President Obama’s signature on the Jumpstart Our Business Startups Act, known as the JOBS Act, on April 5, 2012, the legal framework for crowdfunding, in which entrepreneurs and start-ups raise capital in small amounts from large numbers of ordinary investors, is now law. The JOBS Act amends the Securities Act of 1933 by adding two new Sections, 4(6) and 4A. Together, these new sections exempt crowdfunding transactions from the registration requirements of the Securities Act.
Whether Title III of the JOBS Act, where the crowdfunding provisions are found, will satisfy the dreams of the entrepreneurial community by providing efficient and low-cost access to capital, whether the burdens of complying with the Act and the forthcoming regulations will mean that crowdfunding is little-used in practice, and even whether crowdfunding will subject unsuspecting and unsophisticated investors to widespread fraud, all remain to be seen. Early predictions vary widely, and the Act’s name for Title III, the ‘‘Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act of 2012,’’ gives some hint of the debate.
But there is no question about either the momentum behind crowdfunding or its bipartisan political support. The original crowdfunding bill, the Entrepreneur Access to Capital Act, was approved by the U.S. House of Representatives in November 2011 by a margin of 407 votes to 17. The House later incorporated that bill into the JOBS Act, which it passed on March 8, 2012. The U.S. Senate approved a slightly amended version of the JOBS Act on March 22, by a vote of 73 to 26; and the House approved the Senate-amended version on March 27, in a 380 to 41 vote. The President had publicly supported the Entrepreneur Access to Capital Act since November 2011.1
How useful the new exemption will ultimately be will depend in large part on the regulations that must be adopted by the Securities and Exchange Commission to implement the new statute. Final regulations must be adopted by December 31, 2012 (270 days of the statute’s enactment).
Until regulations are adopted — or at least proposed — companies hoping to take advantage of the possibilities of crowdfunding, and their counsel, are in a state of limbo. Nevertheless, the Act is detailed enough that understanding its provisions is worthwhile. What follows is an analysis of the statute, of what entrepreneurs and investors may expect, and of steps companies should consider taking to prepare themselves for crowdfunding.
Any company, or “issuer,” organized under the laws of a state or territory of the United States or the District of Columbia that is not already subject to the reporting requirements of the Securities Exchange Act of 1934 may use the crowdfunding exemption to raise capital. Among the rules the SEC must adopt, however, are so-called “bad actor” disqualification provisions for both issuers and intermediaries. These disqualification provisions must be substantially similar to the provisions of Rule 262 under the Securities Act.
Each issuer may raise up to $1,000,000 through crowdfunding transactions within any 12-month period. This limit is subject to adjustment by the SEC, at least once every five years, to reflect changes in the Consumer Price Index for All Urban Consumers published by the Bureau of Labor Statistics.
Probably not. The Act orders the SEC to adopt rules that exempt, “conditionally or unconditionally,” securities acquired in a crowdfunding transaction from the provisions of Section 12(g) of the Exchange Act. But for this exemption, purchasers of securities in a crowdfunding transaction would have been included in the calculation of the number of stockholders of record of an issuer for purposes of determining whether the issuer is required to register under the Exchange Act.2 The phrase “conditionally or unconditionally” in the Act, however, may open the door for the SEC to impose some limits, at least under some circumstances.
The Act limits the amount any individual investor may invest in any one issuer:
For purposes of the Act, an individual investor’s income and net worth will be calculated in accordance with SEC rules on the calculation of the income and net worth of accredited investors, and these amounts are also subject to adjustment by the SEC, at least once every five years, to reflect changes in the Consumer Price Index.
Issuers must use an intermediary — either a securities broker or a “funding portal” — to reach prospective investors and to facilitate crowdfunding transactions. Issuers may not advertise the terms of their offering, but may publish notices and use the internet to direct investors to their intermediary.
Intermediaries will be required, among other things, to register with the SEC; to register with any applicable “self-regulatory organization”; to make disclosures to prospective investors about the risks of the investment and other disclosures the SEC may prescribe; to “positively affirm” that each investor understands that the investor is risking the loss of the entire investment and that the investor can bear that loss; to ensure that no investor invests more than the Act permits; to take measures to reduce the risk of fraud, including conducting background and securities enforcement regulatory checks on each officer, director and holder of 20% or more of the equity securities of the issuer; to ensure that, if the offering has a minimum fundraising target, no funds are released to the issuer until that target is reached; and to comply with any other rules the SEC may adopt.
A “funding portal” under Section 4A is any intermediary involved in the offer or sale of securities in a crowdfunding transaction under Section 4(6). Unlike brokers, however, funding portals may not (i) offer investment advice or recommendations; (ii) solicit purchases, sales or offers to buy the securities offered or displayed on its website or portal; (iii) compensate employees, agents, finders or other persons for such solicitation or for supplying the portal with the personal identifying information of potential investors; (iv) hold, manage, possess or otherwise handle investor funds or securities; or (v) engage in any other activities the SEC may prohibit. While not yet registered with the SEC, of course, Boston-based Wefunder, which has received pledges from approximately 4,000 people to invest more than $9,600,0003 and has announced that it is building a crowdfunding platform, may become one of the early funding portals.
The broker or funding portal, of course, will need to be compensated for its services. The Act does not directly regulate compensation. Instead, it requires the SEC to adopt rules to ensure that issuers do not compensate anyone, directly or indirectly, for promoting their crowdfunding offerings without taking such steps as the SEC may require to ensure that all such compensation, past or prospective, is adequately disclosed in each promotional communication about their offerings.
In short, quite a lot, which may mean that entrepreneurs who had hoped for a truly streamlined, “do-it-yourself” approach to raising relatively modest amounts of capital may wind up being frustrated. Each issuer will be required to provide investors and the relevant broker or funding portal — and file with the SEC — at least the following information:
(i) the issuer’s name, legal status, address and website;
(ii) the names of the issuer’s directors and officers and of each person holding more than 20% of its equity securities;
(iii) a description of the issuer’s business and its anticipated business plan;
(iv) a description of the issuer’s financial condition, including:
(v) a description of the intended use of the proceeds of the offering;
(vi) the target offering amount, the deadline to reach that target offering amount and regular updates on the issuer’s progress toward meeting the target;
(vii) the price of the securities or, if the price is not known at the time the investor commits to the investment, the method for determining the price; in that event, prior to the actual sale, each investor must also be provided the final price and all required disclosures, with a reasonable opportunity to rescind the investment commitment;
(viii) a description of the issuer’s ownership and capital structure, including:
(ix) such other information as the SEC may prescribe.
Issuers that do all that are not done yet. They will also be required, at least annually, to file ongoing reports, including financial statements, with the SEC and to make those reports available to investors. The SEC will adopt rules to determine the scope of the required reports as well as any applicable exemptions and termination dates. In addition, issuers will be required to comply with such other requirements as the SEC may adopt for the protection of investors.
Absolutely, which means that issuers who attempt to crowdfund without good legal counsel run significant risks. Any investor who purchases a security in a crowdfunding transaction has a “rescission right” — the right to recover his entire investment, with interest — if the issuer made any material misstatement, whether orally or in writing, or if the issuer omitted some material information from the offering documents. Liability is personal and not just limited to the company itself. For this purpose, the term “issuer” includes (i) the issuer’s directors or partners, (ii) the issuer’s principal executive officer or officers, principal financial officer and controller or principal accounting officer and (iii) and any other person who offers or sells the security.
Although the Act is not crystal clear, it appears that the company’s intermediary would be a “person who offers or sells the [company’s] security” and would therefore have the same liability as the company itself. To avoid this liability, the intermediary would have to prove that it did not know, and in the exercise of reasonable care could not have known, of the material misstatement or omission. Unless the regulations clearly state that intermediaries are not “issuers,” companies should expect their intermediaries to play an active role in the preparation of their disclosure documents.
Just as with offerings under Rule 506 of Regulation D, the JOBS Act preempts state law and prohibits the states from adopting registration or offering requirements for securities issued under the crowdfunding exemption. In a departure from Rule 506 preemption, however, only the state in which the issuer’s principal place of business is located and any other state in which purchasers of at least 50% of the aggregate amount of the issue are residents may require any notice filing or filing fee. Similar restrictions apply to the state regulation of funding portals. Nothing in the Act, however, limits the authority of any state regulator to take enforcement action against any issuer, funding portal or any other person using the crowdfunding exemption, and the Act specifically directs the SEC to make the information filed by issuers with the SEC available to state regulators.
Interestingly, in what may have been a bone thrown to state regulators, the Act specifically directs the SEC, when adopting its rules, to consult with any state securities commission which seeks to consult with the SEC and with any applicable national securities association. Entrepreneurs should expect state regulators to use this mandate to exert their influence on the final regulations.
Investors purchasing securities in a crowdfunding transaction are generally prohibited from selling them for one year after their purchase. Purchasers may sell them anytime, however, back to the issuer; to accredited investors; as part of a public offering registered with the SEC; to a member of the purchaser’s family; and in connection with the death or divorce of the purchaser or “other similar circumstance,” in the SEC’s discretion. Resales of crowdfunded securities will be subject to other rules that the SEC may adopt. The legal ability to resell crowdfunded securities is one thing; the development of an actual secondary market is quite another. It will be interesting to see whether funding portals or established online marketplaces such as SharesPost, which currently focus on linking institutional and angel investors to larger, often venture-backed, private companies, will help to facilitate resales of crowdfunded securities.
Until the SEC adopts rules implementing the Act, there is probably little that would-be issuers can do to actually raise capital in crowdfunding transactions. However, they can get ready by taking the steps any company should take today before trying to raise capital. Foremost, issuers and their officers should start by asking what is compelling about their company – why would anyone want to invest in them? What’s the business plan? What’s the exit strategy?
Next, issuers should take a hard look at their capital structure, legal environment and corporate infrastructure. Among the questions to explore: If the company is a “Subchapter S” corporation or some other entity taxed as a partnership, should it become a “Subchapter C” corporation? If so, when is the optimal time to make the change? Does the company have enough shares authorized? Do its charter and by-laws permit majorities to take actions without calling formal stockholder meetings? Is the company incorporated in a state with laws “friendly” to officers and directors? Do its charter and by-laws contain strong indemnification protections for directors and officers? Should the company obtain directors’ and officers’ liability insurance? Should the company consider issuing nonvoting stock to its crowdfunding investors? Are other laws – everything from state antitakeover laws to laws applying to minority-owned or women-owned businesses – implicated by the potential offering? What about banking arrangements and other contractual commitments?
Issuers should also consider what doing business as a quasi-public company will be like. Does management have the ability and the temperament to communicate regularly and openly with its investors, or will that feel like a burden? Are they prepared for the telephone calls and emails from investors who may be frustrated for any number of reasons? Are they prepared to have the company and its management discussed, sometimes in quite graphic terms, in internet chat rooms? Are they prepared for their competitors to download their disclosure documents from the SEC and try to use their financial statements and disclosures about risks against them in the marketplace?
Even before regulations are issued, issuers may want to prepare initial drafts of their offering and disclosure documents. They should make sure their financial statements and tax returns are in order and sufficient to meet the requirements applicable to their own offering. They should think about their public presence, on the Web and in their product marketing literature. Is the story those documents tell consistent with the offering documents? Although the company’s owners may think they know one another, they should consider getting their own background checks done now, to avoid unpleasant surprises during the offering.
Most important, given the scrutiny that early adopters are likely to face — not to mention the exposure to personal liability of officers, directors and some shareholders for fraud claims – issuers should think very carefully about their businesses and the risks of investing in them. The offering documents must disclose all of those risks in meaningful, plain language. Neither the SEC nor plaintiffs’ securities lawyers lend any credence to boilerplate disclosures, so issuers should make their disclosures describe all of the actual risks of investing in their particular business. While it is difficult to predict how large a role, if any, funding portals will take in helping issuers to prepare their disclosure documents, it is safe to say that they are unlikely to take anywhere near the same care that investment banks take when underwriting public offerings. It is therefore all the more important that prospective issuers consult with competent legal counsel and other professionals to make sure their own due diligence and disclosures are complete.
For more information on crowdfunding or the JOBS Act, please contact Carl Barnes.
Footnotes.
1. Statement of Administration Policy - H.R. 2930 - Entrepreneur Access to Capital Act (November 2, 2011).
2. Section 12(g) was itself amended by the JOBS Act, and now requires an issuer to register under the Exchange Act within 120 days after the last day of the issuer’s first fiscal year on which it had total assets exceeding $10,000,000 and a class of equity security (other than an exempted security) held of record by either 2,000 persons or 500 persons who are not accredited investors.
3. As of April 6, 2012.
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