The D & O Diary
SEC Releases Proposed Crowdfunding Rules
On October 23, 2013, the SEC finally approved (unanimously) and released for public comment the proposed rules implementing the crowdfunding provisions of the JOBS Act. The rules will not become effective, subject to any revisions, until the end of a 90-day comment period, meaning that the rules will not go into effect until some time early in 2014. The SEC’s October 23, 2013 press release regarding the new rules can be found here. The proposed rules themselves can be found here.
The JOBS Act, signed into law in April 2012 (about which refer here), contained statutory provisions providing exemptions under the securities laws allowing certain kinds of start up ventures to raise equity financing from non-accredited investors using Internet fundraising platforms. The Act left many of the details to the SEC and directed the agency to release implementing regulations within 270 days. The deadline for the regulations came and went, and as time passed anticipation over the as-yet unreleased regulations grew. Indeed, earlier this week, a bipartisan group of eight U.S. Senators sent the SEC a letter urging the agency to “expedite” the release of the crowdfunding rules.
The proposed rules, which run some 585 pages, provide further specificity as to who may invest and how much they may invest; specifying what information the firm seeking fund raising must provide; and “create a regulatory framework for the intermediaries that would facilitate the crowdfunding transactions.”
Consistent with the Act’s provisions, the proposed rules specify that a company may raise no more than $1 million in any one 12 month period through crowdfunding . The rules also specify that investors may invest up to the greater of $12,000 or five percent of their annual income or net worth if both their annual income and net worth are less than $100,000, or ten percent of their annual income or net worth if their annual income or net worth are greater than $100,000. Securities purchased in a crowdfunding offering could not be resold for one year.
Certain companies would be ineligible for the crowdfunding exemption, including non-U.S. companies; current SEC reporting companies; certain investment companies, companies currently subject to disqualification; companies that have failed to comply with annual reporting requirements in the rules; and “companies that have no specific business plan or that have indicated that their business plan is to engage in a merger or acquisition with an unidentified company or companies.”
The proposed ruled specify that information that companies must provide in the crowdfunding offering documents, including the identities of the company’s directors and officers as well as anyone owning more than 20 percent of the company; a description of the company’s business and intended use of the offering proceeds; and the target price of the offered securities and the intended size of the offering; The offering document must also identify related-party transactions and the financial condition of the company. The offering documents must include the company’s financial statements, which, depending on the size of the offering, may have to be accompanies by a copy of the company’s tax returns or be reviewed or audited by an accountant. The issuing company would have to provide updates of material changes as well as provide updates on the company’s progress toward reaching the target offering amount.
The proposed rules also specify the issuing company’s ongoing reporting requirements after the completion of the offering. This portion of the Act’s requirements has generated a great deal of comment as some observers wanted to minimize the ongoing requirements on the offering companies while others wanted to provide investor protection through reporting requirements. The proposed rules would require companies to file an annual report no later than 120 days after the end of their financial year, with the reports to be filed with the SEC and posted on the company’s website. The company would not be required to provide investors with a physical copy of the report. The annual report would have to include information similar to the information required in the offering document about the company’s business and financial condition. Because the crowdfunding securities are freely tradable after one year, the reporting requirement would be continuous in order to provide potential future investors with information about the company.
The proposed regulations also provide specifications regarding the funding platforms, which must be operated by a registered broker or by a funding portal, which is a new type of SEC registrant. The platforms are required to provide individuals with educational materials; take measures to reduce fraud; make issuer and offering information available; permit discussions on the platform about the offering; and facilitate the sale of crowdfunding securities.
The crowdfunding portals would be prohibited from offering investment advice or making recommendations; soliciting the purchase or sale of the securities offered on its website; avoid paying prohibited compensation and commissions; avoid holding or handling investor funds or securities.
In the discussion in the proposed rules regarding the Act’s liability provisions, the rules affirm that the range of persons who potentially could be held liable for misrepresentations in the crowdfunding offering are involved intermediaries, including the offering platforms. The rules provide that in light of these potential liability provisions, the platforms should “establishing policies and procedures that are reasonably designed to achieve compliance with the requirements of Regulation Crowdfunding, and that include the intermediary conducting a review of the issuer’s offering documents, before posting them to the platform, to evaluate whether they contain materially false or misleading information.”
The agency undoubtedly will receive extensive commentary on the proposed rules, although they are not likely to be as controversial as they potentially could have been because they largely follow the structure laid down in the Act. Based on the comments submitted during the comment period, the rules may be further revised before they are final and companies can commence conducting financing through crowdfunding offerings.
Although we will still have to wait a few months before companies can commence crowdfunding financings, it will be interesting to see when we finally get there how much interest there ultimately will be in raising funds through these kinds of offerings. The limitations put on the amount of funds that can be raised as well as the information requirements for the offerings, along with the annual reporting requirements, may represent burdens that some start up ventures may be unwilling to undertake (especially because they will almost inevitably require the association of outside professionals, including accountants and attorneys).
Another thing that will be interesting to see is the extent of investor interest, particularly if there are (as there inevitably will be) high profile stories about online scams involving crowdfunding financings. I hope I am not being too skeptical, but it just seems inevitable there will be offerings where the issuing company’s principals abscond with the funds or use them for purposes other than those proposed in the offerings. Even if there are no frauds, there inevitably will be innumerable instances where investors lose their money because the company fails or no secondary market forms for the company’s securities.
From an insurance perspective, it will also be interesting to see both how extensively the crowdfunding liability provisions are used and whether a market develops for insurance products providing crowdfunding companies and their directors and officers insurance protection for crowdfunding liability. I suspect that many carriers will develop liability insurance products targeted at crowdfunding companies, but it will be interesting to see if crowdfunding companies are interested in using their limited funds to purchase the insurance.
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