On October 30, 2015, by a 3-1 vote, the SEC adopted final rules to permitting small companies to raise funds by selling shares to the investing public through crowdfunding offerings conducted on Internet fundraising portals. In this long-awaited vote, which represented the last remaining significant rulemaking procedure required by the Jumpstart our Business Startups (JOBS) Act of 2012, the agency finally authorized, in slightly modified form, the rules it had first proposed in October 2013. The agency’s October 30, 2015 press release announcing its action and describing the final rules can be found here. The 686-page adopting release can be found here.
When the new rules finally become effective following the required notice period, they will permit smaller ventures and business startups to raise up to $1 million over a 12-month period through crowdfunding campaigns. It remains to be seen whether or not crowdfunding will prove to be popular with small enterprises, given the regulatory regime the agency has created and other constraints noted below. As also discussed below, the crowdfunding regime also raises both liability and insurance concerns, which may also affect issuers’ willingness to engage in crowdfunding offerings.
The Basics of the Rules Adopted
The rules the SEC adopted do basically three things: first, they permit qualifying companies to raise funding by selling shares through exempt crowdfunding offerings, subject to certain disclosure obligations; second, they permit individuals to purchase shares in crowdfunding offering, subject to certain limitations; third, they create a regulatory framework for the Internet portals that are to serve as the intermediaries for facilitating crowdfunding transactions. The new rules are effective 180 days after they are published in the Federal Register. The forms enabling funding portals to register with the Commission will be effective on January 29, 2016.
Crowdfunding Companies: Under the rules, a company may raise an aggregate of $1 million through crowdfunding offerings in a 12-month period. In order to conduct a crowdfunding offering, a company must file certain information with the Commission and provide the information to investors and to the funding portal, including: the price of the securities offered and the target offering amount; a description of the company’s financial condition; the company’s financial statements (about which see the next paragraph); a description of the company’s business and intended use of the proceeds; the identities of the company’s directors, officers, and owners holding more than a 20% stake in the company; and certain related-party transactions. The company would also be required to file and to provide to investors an annual report.
The final rules relaxed somewhat the financial statement requirements that had been initially proposed. The agency had proposed that if a company sought to raise $500,000 or more in a crowdfunding offering that the company would have to provide audited financial statements. Under the final rules, a company that is conducting its first crowdfunding offering is exempt from the requirement that it provide audited financials, and instead is required to present financial statements that have been reviewed by an accountant.
Crowdfunding Investors: The final rules establish certain limits on the amounts that investor can invest in crowdfunding offerings, based upon investors’ income levels. For investors with annual income or net worth less than $100,000, the annual aggregate amount the investors may invest across all crowdfunding offerings is $2,000 or 5 percent of their net worth. Investors with annual income or net worth greater than $100,000 are limited to 10 percent of their income or net worth annually, in the aggregate across all crowdfunding offerings. During the 12-month period, the aggregate amounts of securities sold to an investor through all crowdfunding offerings may not exceed $100,000.
Crowdfunding Intermediaries: The final rules require funding portals to be registered with the SEC and to become members of FINRA. The rules specify a number of other qualifying requirements for intermediaries as well as operating and process requirements. Among other things, the intermediaries are required to take certain measures to reduce the risk of fraud, including having a reasonable basis to believe that a company complies with the crowdfunding regulations; make company crowdfunding information available on its site prior to, during, and following the offering period; provide disclosures about the intermediaries’ compensation (interestingly, the final rules allow portals to accept company shares in payment for facilitating the offering); and have a reasonable basis for believing that an investor complies with the investor requirements. The rules also specify certain requirements for the transmission of funds, and other process issues.
While there is a certain amount of relief that the crowdfunding rules have finally been adopted, a number of questions remain about whether crowdfunding will prove to be an attractive option for the various process participants.
Among other concerns that have been raised is the question of whether the rules’ filing and reporting requirements will discourage companies from seeking to raise funds through a crowdfunding offering. As Commissioner Michael S. Piwowar noted in his dissent, the various burdens that the rules impose “will spook many small businesses from pursuing crowdfunding.” Others have already suggested that the rules’ procedural and reporting requirements will make crowdfunding an unrealistic option for startups – the very kind of enterprise that the JOBS Act’s provisions were intended to benefit – owing to the burden and expense the regulatory framework entails.
By the same token, the burdens and restrictions proposed for the funding portals may discourage potential intermediaries from becoming involved. Indeed, the failure of funding intermediaries to form and to come forward was one of the significant shortcomings of the intrastate crowdfunding mechanism that the state of Colorado previously launched (as discussed here). Potential intermediaries may also be concerned about the extent to which they have to monitor investors’ compliance with the participation requirements and limitations, as well as the extent to which they may be held liable for issuers’ misstatements or omissions.
For their part, prospective investors may find it challenging to negotiate the maze of limitations on their investment opportunities. And perhaps even more significantly, investors may also be (rightly, in my view) concerned about potential limitations on their abilities to re-sell shares purchased in a crowdfunding offering. As a formal matter under the rules, shares sold in crowdfunding offerings are subject to a one-year holding period. As an informal matter, and as a result of the absence of any existing marketplace for secondary trading of crowdfunding-issued shares, investors may find themselves involuntarily holding shares that, as a result of their illiquidity, wind up having little practical value. This issue of the absence of a market for trading crowdfunding shares was of particular concern in the concurring statement of SEC Commission Luis Aguilar, who emphasized the critical need for the development of a secondary market.
While there are reasons to be concerned about the burdens and limitations that the proposed rules create, it should be noted that there are a number of other things that the rules do not do. For example, some commentators, concerned about the possibility of fraudulent crowdfunding efforts, had proposed the adoption of even more stringent disclosure requirements and limitations (such as, for example, restrictions on ability of issuers to project unrealistic investment returns and limitations on the ability of issuer insiders to use offering proceeds for their own compensation or for their own benefit). It will be interesting to see if experience shows that these kinds of requirements were needed.
Liability and Insurance Concerns
The possibility of fraudulent misrepresentations in connection with crowdfunding offerings does lead to an additional concern – that is, the possibility that directors and officers of crowdfunding companies might be held liable for misrepresentations or omissions the offering. In that regard, it is important to note that Section 302(c) of the JOBS Act expressly imposes liability on issuers and their directors and officers for material misrepresentations and omissions made to investors in connection with a crowdfunding offering. Under Section 302, an investor may bring an action “in any court of competent jurisdiction” seeking to impose liability under Sections 12 and 13 of the Securities Act of 1933. In other words, a private crowdfunding company and its directors and officers could be subject to liability under the federal securities laws
As I noted at the time Congress enacted the JOBS Act, the Act’s crowdfunding provisions blur the clarity of the division between private and public companies. The crowdfunding provisions seem to expressly contemplate that a private company would be able to engage in crowdfunding financing activities without assuming public company registration and reporting obligations. Yet at the same time, that same private company will be required to make certain disclosure filings with the SEC in connection with the offering, as well as make annual report, and could potentially incur liability under the federal securities laws.
These and other aspects of the crowdfunding offering regime present the D&O insurance industry with both theoretical and practical challenges. The industry has already noted these possible challenges, but so far the responses that some carriers have taken have been limited to proposing the addition of crowdfunding exclusions to their existing private company D&O insurance policies (although, to be sure, other carriers have evinced a greater willingness to accept liability for crowdfunding offerings, while attempting to preclude coverage for other types of offerings instituted by the JOBS Act).
Up to this point, the insurance industry has largely treated these concerns as marginal issues, because the rules had not yet been finalized. Now that the final rules are in place and we are about to see the advent of crowdfunding offerings, the question of coverage for crowdfunding activities is about to become much more immediate. It will be interesting to see whether a market develops for insurance products providing crowdfunding companies and their directors and officers insurance protection for crowdfunding liability. If carriers develop liability insurance products targeted at crowdfunding companies, it will be interesting to see if crowdfunding companies are interested in using their limited funds to purchase the insurance. One obvious constraint on the development of a functioning insurance market to address the crowdfunding offering liability exposures is the very small size of the offerings involved.
A related but separate challenge for the insurance industry is the liability exposure of the intermediaries. The extent to which intermediaries may be held liable for misrepresentations of issuers using the intermediaries’ platform remains to be seen, as well as the extent to which intermediaries may be held responsible for failing to monitor the qualifications of investors. These uncertainties could make intermediaries a particular difficult proposition both from liability and an insurance standpoint. The need for the intermediary to process large numbers of small transactions creates a clear risk of execution error, which, along with the final rules’ various operational requirements, could represent an E&O risk for the intermediaries and their insurers.
In the end, the crowdfunding initiative that the JOBS Act launched represents a very interesting experiment in company financing. As noted in an October 30, 2015 Law 360 article discussing the rules (here), the crowdfunding initiative takes the SEC, as well as prospective issuers, investors, and intermediaries, “into uncharted territory by allowing stocks and bonds to be sold to the general public without the registration process that’s been the hallmark of federal securities laws for 80 years.” It will be very interesting to see how this experiment unfolds.
One final observation: only four Commissioners voted on the final rules owing to the vacancy created by the resignation of Commissioner Daniel Gallagher, who left his office on October 2, 2015.
Late Autumn: November 1, 2015, Lower Shaker Lake, Shaker Heights, Ohio.