Two Years and Essentially As Proposed: SEC Adopts Final Crowdfunding Rules

What is “Crowdfunding”?

Crowdfunding is a term often used to describe an evolving method of raising money from individuals through the Internet. The term is often applied to any number of different activities that are worth distinguishing:

• Various internet portals (e.g., FundersClub, AngelList) have, for several years, and pursuant to guidelines set forth in a series of published SEC No Action Letters, allowed companies to raise money selling their securities to accredited investors only. This activity is not directly affected by the SEC’s October 30, 2015 final rules and is not what is meant by “crowdfunding” as discussed in this client alert.
• Various other internet portals (e.g., Kickstarter) have, for several years, allowed companies to raise money for certain projects by soliciting funds from non-accredited investors – but importantly, not by selling securities of the company for investment, but rather by offering participants who provide funds to the company goods or services or priority access to certain company benefits. This activity is also not directly affected by the SEC’s October 30, 2015 final rules and is not what is meant by “crowdfunding” as discussed in this client alert.
• “Crowdfunding” as discussed in this client alert and which is the subject of the SEC’s October 30, 2015 final rules is the method by which companies can use an SEC-registered internet portal in order to offer securities of the company for investment directly to non-accredited investors. Prior the adoption of the new final rules, this activity was generally severely restricted and/or prohibited outright under the federal securities laws, absent a full registration of the offering of securities with the SEC (e.g., an initial public offering on Form S-1) or pursuant to certain very limited exemptions that were not widely used in practice.

Summary of the Final Rules

The final rules will, among other things, (i) enable non-accredited investors to purchase securities for investment in crowdfunding offerings subject to certain limits, (ii) require companies to conduct their offerings through a qualified intermediary and disclose certain information about their business and the securities offering, and (iii) create a regulatory framework for the intermediaries facilitating crowdfunding transactions.

Size of Offering and Individual Investment Limitations

The final rules provide for the following size of offering and individual investment limitations:

• A company is permitted to raise a maximum aggregate amount of $1 million through crowdfunding offerings in any rolling 12-month period;

• Individual investors are permitted, over any rolling 12-month period, to invest in the aggregate across all crowdfunding offerings of all companies of up to:
  • If either their annual income or net worth is less than $100,000, then the greater of:
    • $2,000 or
    • 5 percent of the lesser of their annual income or net worth.
  • If both their annual income and net worth are equal to or more than $100,000, 10 percent of the lesser of their annual income or net worth; and 
• During any rolling 12-month period, the aggregate amount of securities sold to an investor through all crowdfunding offerings of all companies may not exceed $100,000.

Required Filing and Public Disclosure Requirements

Companies that rely on the crowdfunding rules to conduct a crowdfunding offering must publicly file certain information in an “offering statement” with the SEC on the EDGAR platform and provide this information to investors and the intermediary facilitating the offering (discussed further below). The information required in an offering statement includes among other things:

• Information about the company’s officers and directors (including among other things the business experience of each individual over the last three years) as well as the name and ownership levels of beneficial owners of 20 percent or more of the outstanding voting securities of the company (calculated on the basis of voting power);
• A description of the business and the company’s business plan, the current number of employees of the company, a description of any material indebtedness, and the use of proceeds from the offering;
• The price to the public of the securities or the method for determining the price, the target offering amount, the deadline to reach the target offering amount, and whether the company will accept investments in excess of the target offering amount;
• A description of the ownership and capital structure of the company, including among other things the terms of the securities being offered and each other class of security of the company and any restrictions on transfer of the securities;
• A description of the material factors that make an investment in the company speculative or risky, including in particular, the risks to purchasers of the securities relating to minority ownership in the company, the risks associated with corporate actions, including additional issuances of shares, a sale of the company or of assets of the company or transactions with related parties;
• A description of certain related-party transactions;
• A discussion of the company’s financial condition, including a narrative discussion that includes a discussion of liquidity, capital resources and historical results of operations and a discussion of each period for which financial statements are provided (see below) and a discussion of any material changes or trends known to management in the financial condition and results of operations of the company subsequent to the period for which financial statements are provided;
• Annual financial statements of the company prepared under U.S. GAAP (including each of a balance sheet, income statement, statement of cash flows, statement of stockholders equity and notes to the financial statements) covering the shorter of the two most recently completed fiscal years of the company or the period since the inception of the business^[1] – with such financial statements certified, reviewed or audited, depending on the amount of crowdfunding securities offered and sold during a 12-month period, as follows:
  • For companies offering $100,000 or less, financial statements certified by the principal executive officer to be true and complete in all material respects, as well as disclosure of the total income, taxable income and total tax as reflected in the company’s federal income tax returns certified by the principal executive officer;
  • For companies offering more than $100,000 but not more than $500,000, financial statements reviewed (but not audited) by a public accountant that is independent of the company;
  • For companies offering more than $500,000 (but less than the $1 million aggregate cap):
    • If the offering is the company’s first offering under the crowdfunding rules, financial statements reviewed (but not audited) by a public accountant that is independent of the company; and
    • If the offering is not the company’s first offering under the crowdfunding rules, financial statements audited by a public accountant that is independent of the company
• Any other material information about the company necessary in order to make the statements made in the offering statement, in light of the circumstances in which they were made, not misleading.

Companies are also required to amend the offering statement during the crowdfunding offering process to reflect any material changes and provide updates on the company’s progress toward reaching the target offering amount.

In addition, companies relying on the crowdfunding rules will be required to file with the SEC regular annual reports that include all of the information that was required to be included in the original offering statement described above (updated in all respects as applicable to the current date of the annual report) by no later than 120 days after the end of each completed fiscal year. The singular difference between an annual report and the original offering statement is that the financial statements for the most recent fiscal year need only be certified by the principal executive officer of the company to be true and correct in all material respects (unless reviewed or audited financial statements are available for such year, in which case those financial statements must be provided). Companies will be required to continue to file annual reports every year until the earliest of the following:

• The company is otherwise required to file reports under the Securities Exchange Act of 1934 (such as pursuant to an IPO or a registration required under Section 12(g) of the Securities Exchange Act of 1934);
• The company has filed at least one annual report and has fewer than 300 holders of record;
• The company has filed at least three annual reports and has total assets that do not exceed $10 million;
• The company or another party purchases or repurchases all of the securities issued pursuant to crowdfunding offerings, including any payment in full of debt securities and any complete redemption of redeemable securities; or
• The company liquidates or dissolves in accordance with state law.

Required Use of SEC-Registered Intermediaries

All transactions relying on the new crowdfunding rules will be required to take place through an SEC-registered intermediary, either a registered broker-dealer or a “funding portal”. A funding portal will be required to register with the SEC on new Form Funding Portal, and become a member of a national securities association (currently, FINRA). A company relying on the crowdfunding rules will be required to conduct its offering exclusively through one intermediary platform at a time.

The final rules will require intermediaries to, among other things:

• Provide investors with educational materials that explain the process for investing on the platform, the types of securities being offered and information a company must provide to investors, resale restrictions, and investment limits;
• Take certain measures to reduce the risk of fraud, including having a reasonable basis for believing that a company complies with the crowdfunding rules and that the company has established means to keep accurate records of securities holders;
• Make information that a company is required to disclose available to the public on its platform throughout the offering period and for a minimum of 21 days before any security may be sold in the offering;
• Provide communication channels to permit discussions about offerings on the platform;
• Provide disclosure to investors about the compensation the intermediary receives;
• Accept an investment commitment from an investor only after that investor has opened an account;
• Have a reasonable basis for believing an investor complies with the investment limitations;
• Provide investors notices once they have made investment commitments and confirmations at or before completion of a transaction;
• Comply with maintenance and transmission of funds requirements; and
• Comply with completion, cancellation and reconfirmation of offerings requirements.

The final rules also will prohibit intermediaries from engaging in certain activities, such as:

• Providing access to their platforms to companies that they have a reasonable basis for believing have the potential for fraud or other investor protection concerns;
• Having a financial interest in a company that is offering or selling securities on its platform unless the intermediary receives the financial interest as compensation for the services, subject to certain conditions; and
• Compensating any person for providing the intermediary with personally identifiable information of any investor or potential investor.

The final rules include certain provisions that are specific to registered funding portals consistent with their more limited activities than that of a registered broker-dealer. The rules will prohibit funding portals from, among other things: offering investment advice or making recommendations; soliciting purchases, sales or offers to buy securities; compensating promoters and other persons for solicitations or based on the sale of securities; and holding, possessing, or handling investor funds or securities.

Prohibition on Advertising and Publicity

Under the final rules, the only advertisement or public announcement that can be made in connection with a crowdfunding offering is an announcement that says no more than:

• A statement that the company is conducting an offering, the name of the intermediary through which the offering is being conducted and a link directing the investor to the intermediary’s platform;
• The terms of the offering (limited to the amount of securities offered, the nature of the securities, the price of the securities and the closing date of the offering period); and
• Factual information about the legal identity and business location of the company (limited to the name of the company, the address, phone number and website of the company, the email address of a representative of the company and a brief description of the business of the company).

The foregoing prohibition applies not only to the company but to all persons acting on behalf of the company.

Certain Other Restrictions and Securities Law Implications

Under the final rules, certain companies will not be eligible to use the crowdfunding framework. Ineligible companies include non-U.S. companies, companies that are already reporting companies under the Securities Exchange Act of 1934, certain investment companies, companies that are subject to disqualification under the final rules (similar to the “bad actor” disqualification rules recently implemented by the SEC under Rule 506), companies that have failed to comply with the annual reporting requirements under the crowdfunding rules during the two years immediately preceding the filing of the offering statement, and companies that have no specific business plan or have indicated that their business plan is to engage in a merger or acquisition with an unidentified company or companies.

Securities purchased in a crowdfunding transaction generally will not be permitted to be resold by the purchaser for one year. Holders of these securities will not count toward the threshold that requires a company to register its securities under Section 12(g) of the Securities Exchange Act of 1934, if the company is current in its annual reporting obligations, retains the services of a registered transfer agent and has less than $25 million in total assets as of the end of its most recently completed fiscal year.

Discussion and Analysis

Congress passed the JOBS Act in early 2012 (signed into law by President Obama on April 5, 2012) with the stated purpose of facilitating the raising of capital by smaller companies in the United States. Congress directed the SEC in the JOBS Act to write and implement rules to effectuate this mandate, including with respect to providing a framework to allow crowdfunding by smaller private companies. From the very beginning of the SEC’s rulemaking process with respect to crowdfunding, it became clear that the SEC (with vocal input from various state securities law commissioners and regulators) was extremely focused on making sure that any final crowdfunding rules and framework would provide non-accredited investors with significant protections against potential fraud and abuse of the new rules. 

The stark tension between the two goals of facilitating capital formation for smaller companies and providing non-accredited investors with sufficient protections against fraud and abuse has been clear throughout the SEC’s rulemaking process. When the SEC first proposed rules for crowdfunding in October 2013, many commentators and practitioners were concerned that the SEC had erred too far on the side of providing investor protection, to the point that the disclosure and other ongoing reporting requirements required by the proposed rules would, in actual practice, severely discourage smaller companies from raising capital through crowdfunding because of the substantial burden and expense associated with disclosure, reporting and compliance.

Two years later, the final rules are here and this tension is unresolved. Perhaps the most notable accommodation made by the SEC for companies from the proposed rules to the final rules is that for offerings of more than $500,000 (but less than the $1 million aggregate cap), a company using the crowdfunding rules for the first time will be permitted to provide financial statements that have merely been “reviewed” by an independent public accountant and not formally audited (as had been the case in the proposed rules). Other than this accommodation for “first-time” crowdfunding issuers, however, the final rules are essentially as proposed in October 2013, and we expect that commentators and practitioners alike will continue to question whether the SEC has struck the right balance between facilitating capital formation and protecting investors.

What Should Companies Do?

Companies should talk to their advisors and weigh the costs and benefits of crowdfunding before doing anything. A company should at a minimum consider whether it has available (or could easily or inexpensively obtain) the required financial statements to provide to investors, and whether it is willing to broadly disseminate that information to the public, which of course inherently means that such information would be available to potential competitors, commercial counterparties, business partners and the press, among others. 

A company should also consider whether it wishes to publicly disclose detailed information about the company’s financial condition, its capital structure, its sources of financing and liquidity, the identity and background of its officers and directors, the identity of its significant stockholders and other related party transactions. In many cases, this company information would remain strictly confidential during more traditional private financing rounds conducted under Regulation D until a company sought to formally register its securities for sale to the public under the Securities Act of 1933. If a company is generally comfortable making such information public, the company should also work closely with its advisors to model out the expected costs and expenses associated with preparing and drafting initial filings with the SEC and with the ongoing compliance requirements under the final rules.

A company should also consider the potential corporate governance benefits and challenges of having a very dispersed investor base composed of small individual “mom and pop” investors that are not employees or otherwise affiliated with the company. In some cases, we could imagine this being seen as a positive, if potential investors are thought to be composed largely of “early adopter” consumers who are enthusiastic about the company and its products or services and desire to see the company succeed. On the other hand, depending on the composition of a company’s existing stockholder base, the addition of a very dispersed group of new stockholders can make it administratively and practically challenging to approve significant corporate transactions that require stockholder approval, and crowdfunding stockholders could have very different expectations or desires about the time to liquidity or return on investment as compared to traditional professional investors such as venture capital funds and private equity funds with significant experience making these types of early stage investments.

In sum, it is a positive development that after over two years of delays the SEC has finally moved forward on final crowdfunding regulations, but it remains to be seen whether the SEC has struck the right balance between facilitating capital raising and protecting non-accredited investors. Only time (and the actions of the capital raising market) will provide these answers.