SEC Adopts Regulations Implementing “Regulation Crowdfunding” Under Section 4(a)(6) Of the Securities Act
On October 30, 2015, the Securities and Exchange Commission voted to adopt “Regulation Crowdfunding” (Regulation CF). Regulation CF is the set of rules and forms that will implement securities crowdfunding in the United States. The SEC was required to adopt these rules under the provisions of Title III of the JOBS Act of 2012. The final rules come after the SEC reviewed and considered over 485 comment letters from professional trade associations, investor organizations, law firms, investment companies and investment advisers, broker-dealers, potential funding portals, members of Congress, the SEC’s Investor Advisory Committee, state securities regulators, government agencies, potential issuers, accountants, and other interested parties. The rules will go into effect on May 16, 2016, although entities that wish to act as broker-dealers and “crowdfunding portals” under Regulation CF will be able to start the application process from the end of January. The changes from the SEC’s proposed rules originally published in October 2013 are limited, and almost all those changes fall on the side of reducing burdens on the issuer. Of note is the fact that first-time issuers under the new rules will not be required to have their financial statements audited, and ongoing reports are not required even to be reviewed by an accountant. Additionally, the rules increase the ability of crowdfunding portals to use subjective criteria in deciding which companies’ offerings to host on their sites, and to invest in those offerings. From a technical perspective, the fact that the SEC has made it possible to file documents in PDF form will reduce the logistical burden on issuers. On the negative side, individual investment limits were reduced to be based on the lesser of a person’s income or net worth. Additionally, the exclusion of crowdfunding shareholders from the “shareholder of record” count that triggers full registration with the SEC has become conditional.
Three weeks prior to the SEC adopting its final rules, FINRA, which is the self-regulatory organization for broker-dealers and which will also oversee the new “funding portals,” submitted its final Funding Portal Rules to the SEC for final approval.
Section 4(a)(6) of the Securities Act, the “crowdfunding exemption”
Offers of securities to the public (which includes offers made over the internet) must be registered with the SEC under the Securities Act of 1933, unless an exemption from registration is available. The JOBS Act added a new exemption to the Securities Act, Section 4(a)(6), to permit securities crowdfunding without registration. The exemption is subject to the following statutory conditions: The aggregate amount sold to “all investors,” including any amount sold in reliance on the new exemption, may not exceed $1 million in any 12-month period. The language of the statute (the JOBS Act) suggests that offerings made under other exemptions (Regulation D, for example) might count towards the $1 million limit, but the SEC’s view is that since Congress intended crowdfunding to be an additional source of funds for small companies, the limit applies solely to sales under Section 4(a)(6), and that amounts sold under other exemptions will not affect the limit. As discussed below, the SEC will permit crowdfunding offerings to be made concurrently with other exempt offerings, effectively permitting unlimited sizes of offerings to be made without registration.
An investor is limited in the amount he or she may invest in crowdfunding securities in any 12-month period:
For calculating an investor’s net worth, Regulation CF uses the same method as used in Regulation D, which excludes the value of the investor’s primary residence. Investors may include their spouse’s income for the purposes of the income test. The “lesser of” standard is a change from the proposed rules, which took a “greater of” approach to calculating the investment limit based on income or net worth. This change will significantly limit the funds available from non-accredited investors. However, the SEC’s rules permit concurrent offerings under Section 4(a)(6) and Rule 506(b) or (c), which may effectively result in accredited investors not being subject to any limit on their investment.
The transaction must be made through a broker, or through a “funding portal” (a new designation under the Securities Exchange Act of 1934) that meets the requirements set out below. The issuer must comply with the disclosure and other requirements set out below. Note that compliance with each of these requirements is a condition to availability of the exemption from registration. If these conditions are not met and the relief for “insignificant deviations” discussed below is not available, then the issuer will have violated the Securities Act by making an unregistered offering of securities to the public.
Requirements for issuers - Incorporation and eligibility
The issuer must be incorporated or organized under the laws of a state or territory of the United States, or the District of Columbia. It may not be an “investment company” as defined under the Investment Company Act of 1940 and cannot be an SEC-reporting company. “Blank check” companies formed for unspecified purposes or to acquire other companies cannot make offerings under Regulation CF. Additionally, the exemption is not available to any issuer that is disqualified by reason of the bad actor disqualification, or if the issuer (or any entities controlled by or under common control with the issuer) has previously offered securities under Regulation CF and failed to file its ongoing reports with the SEC.
Many commentators urged the SEC to allow issuers to be able to issue securities using single purpose funds. This would avoid the “messy cap table” problem identified by some angel and venture capital investors who do not want to have to deal with numerous small investors in a company. However, the SEC declined to create such an exemption, citing Congressional intent and the language of the statute, which specifically excludes investment companies from being able to rely on Section 4(a)(6).
When determining issuer eligibility for funds to be raised and financial statements requirements, the SEC has clarified the language contained in the statutory text of Section 4(a)(6) that the definition of issuer includes all entities controlled by or under common control with the issuer and any predecessors of the issuer. For example, a single real estate developer that is raising funds for multiple issuers is subject to a 12-month cap of $1 million raised under Regulation CF aggregated across all issuing companies. Additionally, if an issuer controlled by that developer had made a previous offering under Regulation CF, then all future offerings in any company controlled by the
developer more than $500,000 would be required to include audited financial statements.
The definition of common control may also have an impact on franchisees. If the franchise agreement controls the issuer and all other franchisees (i.e., has the power to direct or cause the direction of the management and policies of the entity), then all franchisees would be aggregated together when determining amounts offered and sold under Regulation CF and the financial statements to be required.
Disclosure
The SEC requires that issuers provide certain information to investors through the intermediaries’ platforms and to the SEC directly via a filing of Form C on EDGAR, the SEC’s data handling system. Form C will consist of XML-fillable fields in the front portion of the Form and then “Exhibits” which will include the rest of the information required to be filed. Some information is mandatory, but the issuer may include other information in the Form. The mandatory information for each issuer includes:
A description of the ownership and capital structure of the issuer. This requirement also includes:
Other than the information about the issuer that is required to be entered the XML portion of the Form C (which is covers things like name, address, size of offering, etc.), the SEC does not specify the format or medium in which the mandatory disclosure must be presented, leaving flexibility for crowdfunding issuers to present some information in written offering documents, some in videos, and other information by graphic means.
In response to suggestions made in the comment process, the SEC includes an optional Question and Answer (“Q&A”) format that an issuer can follow to provide the mandatory disclosure not covered by the XML portion of the Form. While this might assist some issuers, who have not sought professional advice to make sure that they do not miss any important items, the Q&A itself is quite technical, and uses securities concepts such as “beneficial owner” and “material terms of outstanding classes of securities” which may be confusing to non-lawyers.
All information about an offering posted on an intermediary’s site must be filed with the SEC via its electronic EDGAR data-handling system. The wording of the SEC’s original proposals suggested that while the mandatory disclosure would have to be filed on Form C, it might be possible to post on the intermediary’s website additional information that did not have to be filed. The SEC has made it clear that this is not the case. Online offerings, currently normally made in reliance on the exemption from registration provided by Regulation D, use a variety of offering materials, including offering memoranda, slide decks, videos and other materials. All these will need to be filed, but the SEC has made that process easier by permitting the filing of data in PDF format (not permitted in other types of SEC filing). Video and audio cannot be filed through EDGAR; a transcript must be filed instead. Not only must all these optional materials be filed, but the issuer (and in some circumstances the intermediary, as discussed in “Liability” below) is liable for any misstatements made in them.
Financial statements
Issuers of securities under Regulation CF are required to provide financial statements prepared in accordance with US Generally Accepted Accounting Practices (U.S. GAAP) covering the two most recently completed fiscal years (or shorter period since inception). The type of review that these financial statements have to undergo depends on the amount sought, the amount of securities that the issuer has already sold in reliance on Regulation CF in the preceding 12 months, and whether the issuer has previously sold securities in an offering under Regulation CF:
The financial statements are not permitted to be more than 18 months old. If more than 120 days has passed since the end of the most recently-ended fiscal year, the issuer will have to produce financial statements for that most recent year, but until that point could use financial statements from the preceding year. No interim financials are required. The review standards to be used by the accountant are the Statements on Standards for Accounting and Review Services issued by the American Institute of Certified Public Accountants. While there has been widespread applause at the more flexible position taken by the SEC in the final rules with respect to audit requirements, issuers should realize that the review process is a substantive one and that if they have been using simple financial statement software like QuickBooks, the reviewing CPA is likely to require them to revise, reformat and expand their financial statements to meet GAAP requirements. One issue that startups with revenue should pay attention to is their revenue recognition policies.
The SEC does not exempt very early-stage companies from these requirements. The SEC reiterated its position in the Proposing Release that “financial statements prepared in accordance with U.S. GAAP are generally self-scaling to the size and complexity of the issuer, which reduces the burden of preparing financial statements for many early stage issuers.” Thus, even companies at the business plan stage seeking $500,000 would have to produce financial statements reviewed by a CPA.
Issuer Filing Requirements and Form C
The Form C must be filed and made public prior to the start of the offering. This means that no “exclusive first look,” either by the issuer or any intermediary, will be permitted. All potential investors must have access to the offering at the same time. Regulation CF creates a new XML-based fillable form, Form C, for use in allowing issuers to provide required information. There are several variants of Form C:
Form C will be used for the provision of some of the mandatory information in XML format, with other required disclosures being submitted as an attachment to Form C. Those attachments can be in PDF form, which is a new and very welcome development for the EDGAR filing process. (The attachments can also be in “EDGAR HTML” or ASCII.) As discussed above, so long as all the mandatory information is filed and presented to investors, the media used to present that disclosure are not specified by the SEC.
When information is presented in the form of video, the text of the video script must be filed; the EDGAR system does not handle video files.
Regulation CF requires issuers to file Form C with the SEC via EDGAR, as well as providing the Form C to the intermediary, investors, and potential investors; however, it allows issuers to satisfy this latter requirement by providing the intermediary with a copy of the disclosures provided to the SEC and directing investors to the intermediary via email or the issuer’s website. To file a Form C the issuer must have EDGAR filing codes and a Central Index Key (CIK) code. If an issuer does not already have these codes it can obtain them from the SEC. The issuer may also work with an intermediary to prepare the disclosures and have the intermediary submit the Form C.
The SEC does not review, comment on or in any way approve the disclosure. It would be foolish, however, to assume that the SEC will not read information that is on EDGAR. An investor protection agency cannot be expected to look the other way if it sees information that it finds troubling, and issuers should operate on the assumption that the SEC staff and the state regulatory authorities will be scouring the Forms C that are filed for potentially misleading statements.
Ongoing disclosure requirements
Issuers that have sold securities in reliance on Section 4(a)(6) must file information with the SEC and post it on their websites on an annual basis. The annual filing must be made within 120 days of the issuer’s fiscal year-end. The information included in the annual report is like that required in the initial filing, except that, in response to numerous objections to the burden of ongoing reporting as originally proposed, no accountants’ audit or review of the financial statements will be necessary.
Regulation CF provides for five ways in which a company can cease filing ongoing reports with the SEC. Annual filing requirements continue until:
The ability for an issuer to cease filing if it has 300 or fewer holders of record, or assets not exceeding $10 million, is a modification from the proposed rule. These changes mitigate some of the compliance cost for small companies that have issued securities under Regulation CF, as does the elimination of the requirements for CPA review or audit.
Advertising and publicity
Pursuant to Section 4A(b)(2) of the Securities Act, an issuer may “not advertise the terms of the of the offering, except for notices which direct investors to the funding portal or broker.” Under the new rules, an issuer and any person acting on behalf of the issuer may publish a limited notice (sometimes called a “tombstone”) that advertises the terms of an offering so long as the notice includes the address of the intermediary’s platform on which information about the issuer and offering may be found. While acknowledging that the statute restricts the ability of potential issuers to advertise, the SEC has explained that restrictions on advertising the terms of the offering are meant to direct the investors to the intermediary’s platform. Once at the intermediary platform, the investors will have access to the information that will allow them to make an informed decision about the offering. Under the rules, a notice advertising the terms of an offering may contain no more than the following (it can contain less):
The rules do not place restrictions on how the issuer distributes these notices, the format of the notice, or its medium. Issuers can use social media, audio, video or street theater, so long as only the permitted content is included. An issuer could place these notices on various social media sites to attract potential investors and the notice would direct them to the intermediary page where they could access the information necessary to make an informed investment decision.
No other public communications about the offering are permitted. Posts on Facebook, tweets on Twitter, LinkedIn updates and the like that do not follow these limitations would all likely result in the issuer’s violation of Section 5 of the Securities Act.
Under the rules, an issuer can communicate with investors and potential investors about the terms of the offering through communication channels provided by the intermediary through its platform, so long as the issuer identifies itself as the issuer in all communications. Anyone acting on behalf of the issuer must identify their affiliation with the issuer on all communications on the intermediary’s platform. The SEC has clarified that the restrictions apply only to persons acting on behalf of the issuer. If a person whose only connection to the issuer was that she loved the company’s product were to tweet that she intended to invest because the company was sure to succeed, this would be unlikely to be a problem for the issuer.
Issuers may engage third-parties to promote the offering in two contexts – through the communication channels provided by the intermediary, and through tombstone notices.
Intermediaries are required to create communication channels on their platforms to facilitate discussion between prospective investors and the issuer (see below). Regulation CF anticipates instances where the issuer will have paid a promoter to respond to investors through those communication channels. In that situation, such compensation must be disclosed by the promoter with any communication on the platform. The second context involves payments to third-parties for publishing tombstone notices that direct to the intermediary’s offering page.
Regulation CF states that an issuer may not pay a third party to do what it cannot do itself. Paid promoters should consider whether the disclosure requirements of Section 17(b) of the Securities Act apply to them. An issuer would not be prohibited from disseminating other information about the company in the normal course of its business that does not relate to the terms of the offering, such as general business advertising.
Requirements for intermediaries
The following requirements apply to both broker-dealers and funding platforms; funding platforms will be subject to some limitations on their activities discussed in “Special limitations on funding portals” below.
Registration
A person acting as an intermediary in a transaction involving the sales of securities for someone else pursuant to Section 4(a)(6) must:
Obligations with respect to fraud prevention and compliance
The statute requires intermediaries to take risks to reduce the risk of fraud, and Regulation CF requires intermediaries to take positive action in several areas: Intermediaries must have a “reasonable basis for believing” that the issuer has met the disclosure and process requirements described below. An intermediary may rely on issuer representations to form that reasonable basis for belief. However, the SEC emphasized that an intermediary has a responsibility to assess whether reliance on representations is reasonable, given its course of interactions with potential issuers. This means that the representation must be detailed enough to evidence a reasonable awareness by the issuer of its obligations and its ability to comply with those obligations. As a result, this requirement cannot be met with a simple representation (“checking the box”) that the issuer has complied with Regulation CF, but requires an inquiry into the issuer and the steps it has taken to comply with Regulation CF.
Intermediaries must have a “reasonable basis for belief” that the issuer has established a way to keep accurate records of the holders of securities. Similarly, with the reasonable basis for belief as to issuer compliance, the SEC provides that an intermediary may accept representations from an issuer that it has established a means to keep track of securityholders. However, any such representation from the issuer must detail record keeping functions such as:
The intermediary must deny access to its platform if it has a reasonable basis to believe that any specified person is subject to a “Bad Actor” disqualification. This requirement is tied to the statutory mandate under Section 4A(a)(5) of the Securities Act that an intermediary conduct a background and securities enforcement regulatory history check on the issuer and its covered persons. To meet this requirement, the intermediary must conduct these checks on the issuer, predecessors of the issuer, officers and directors (or any person occupying a similar status or performing a similar function), and any 20 percent beneficial owner of the issuer.
The intermediary must deny access to its platform if it has a reasonable basis to believe that the issuer or the offering presents the potential for fraud or otherwise raises concerns about investor protection. Here, the intermediary must be able to adequately and effectively assess the risk of fraud from the issuer or its offering and may not ignore facts about the issuer that indicate fraud or investor protection concerns. If it cannot adequately assess the issuer or resolve concerns, the intermediary must deny access to its platform. This may occur, for example, where an issuer’s directors are foreign nationals whose country of origin does not allow for third parties to review criminal or regulatory enforcement background information. If it becomes aware of the potential for fraud after granting access to its platform, it must cancel the offering. The SEC does not further define what constitutes “concerns about investor protection,” and creates some ambiguity as to what is required of intermediaries.
Opening of investor accounts
An intermediary may not accept any investment commitment from investors in a transaction under Regulation CF, until that investor has opened an account with the intermediary and consented to electronic delivery of materials. The SEC does not specify the exact information that the intermediary must obtain from an investor and leaves it to intermediaries to determine what they will require for business purposes and compliance purposes. The requirements that investors consent to electronic delivery of information is important for the functioning of securities crowdfunding. As almost all activity related to the offering and ongoing reporting will be delivered electronically via email, by being directed to a URL, and through the intermediary’s portal, investors are required to consent to such delivery of information in lieu of paper mailings.
Notices regarding promoters of the issuer
At the time that an investor opens an account with an intermediary, the intermediary must inform the investor that anyone who promotes an offering in exchange for compensation, or who is a founder or an employee of an issuer promoting the issuer through the communication channels on the platform must disclose the fact that he or she is engaging in promotional activities on behalf of the issuer. The SEC believes this requirement will assist investors by alerting them at the outset about the promotional activities of issuers or representatives of issuers.
Compensation disclosure
An additional notice requirement for intermediaries when establishing an account for an investor includes disclosure of the way they will be compensated in connection with offerings and sales made in reliance on Section 4(a)(6). For a platform that will accept a range of compensation types from issuers (e.g., flat fee, commission, equity interest, etc.), each type of compensation that it will accept must be disclosed. The SEC determined that this requirement is better suited to the time of an investor’s account opening rather than prior to the point when an investor makes an investment commitment because it will help investors make better-informed decisions when reviewing offerings on the platform.
Provision of educational materials
As part of the statutory requirements for offerings under Section 4(a)(6), intermediaries are required to provide disclosures and investor educational materials. Regulation CF requires these educational materials to be provided to investors at the time they open accounts with intermediaries. Regulation CF further requires that the materials be written in plain language and otherwise designed to communicate effectively specified information. These materials are required to cover:
The circumstances under which an issuer may cease to publish annual reports and the corresponding absence of current financial information about the issuer.
The SEC declined to develop its own investor educational materials for the purpose of this requirement, instead leaving it to each platform to determine the best means to educate their investors. These educational materials must be made continuously available. Should the intermediary make material revisions to its educational materials, it must provide the updated materials to all investors prior to accepting any additional investment commitments or effecting any further transactions.
Acknowledgement of risk
Prior to accepting any investor commitments for any particular offering, Regulation CF requires that intermediaries receive a representation from the investor that the investor has reviewed the educational materials and understands that the entire amount of the investment is at risk and may be lost. Additionally, intermediaries must require investors to complete a questionnaire that demonstrates the investor’s understanding that:
Investing in securities sold under Section 4(a)(6) involves risk and that the investor should not invest any funds unless the investor is able to bear the entire loss of the investment. The SEC declined to develop such a questionnaire and instead left it to the discretion of intermediaries. The SEC stated that this flexibility will allow intermediaries to tailor questionnaires to the business and likely investor base of the intermediary. Intermediaries may require additional information in these questionnaires, such as information concerning the investor’s level of investment experience, where the investor acquired any information about the offering, and the percentage of the investors liquid net worth represented by the proposed investment.
Whatever format the process may take, the intermediary will be required to receive the representation and questionnaire responses from the investor each time an investor makes an investment commitment even if the investor has previously made investments through the intermediary. Requirements for intermediaries with respect to transactions The SEC sets out the methods by which an intermediary must comply with the statutory requirements for managing offerings taking place under Section 4(a)(6) in in Rules 303 and 304. Intermediary must make issuer information available During the course of an offering, the intermediary must make the issuer’s required disclosure information publicly available on the intermediary’s website. This information must be available for at least 21 days prior to any sale of securities and displayed in a manner that allows for any visitor, including regulators, to access, download, and save. This rule poses compliance challenges for intermediaries. First, it is unclear how an issuer’s amendment to its disclosure information impacts the 21-day availability requirements prior to sale. Second, it is possible an intermediary will be liable for allowing sales to occur if the issuer has not supplied the complete set of information it is required to disclose. As such intermediaries must ensure that issuer’s disclosures are complete. The intermediary is not required to ascertain whether investors have reviewed the disclosure material.
Investor qualifications
Intermediaries are responsible for ensuring an investor stays within the annual investment limit. To comply with this requirement, intermediaries must have a reasonable basis for believing that the investor satisfies his or her annual investment limit. An intermediary may rely on investor representations concerning the investor’s annual income, net worth, and the amount of the investor’s other investments made under Section 4(a)(6). Additionally, for each transaction, intermediaries are required to obtain a representation from an investor that the investor has reviewed the educational materials and require the investor to complete a questionnaire covering the restrictions on the ability of the investor to cancel the investment commitment, the limitations on resale of securities, and the riskiness of transactions under Section 4(a)(6).
Communication channels for issuers and investors
Regulation CF is designed on the premise that crowdfunding requires the crowd to be able to communicate with each other and with the issuer to evaluate the investment opportunity. As such, the final rules require that the intermediary establish communication channels on the intermediary’s platform to provide a centralized and transparent means for members of public to asset the investment offering. Specifically, the intermediary must:
If a funding portal, not participate in the communications other than to establish guidelines for communications and remove abusive or potentially fraudulent communication. The SEC leaves open to intermediaries whether to allow their registered users to post under their real names or under aliases. Either choice will affect the quality of communications presented. For example, real names might limit participation, but aliases could encourage inaccurate or abusive posts. Other considerations for intermediaries when establishing communication channels include objective enforcement of communications. For instance, promotion of a positive comment or removal of a negative comment that is not abusive may be considered the provision of investment advice.
Providing notices to prospective purchasers
Upon receipt of an investment commitment, the intermediary must provide the investor with a notification disclosing:
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