Equity Crowdfunding Rules Proposed

On October 23, 2013, the Securities and Exchange Commission (SEC) proposed rules under the Jumpstart Our Business Startups (JOBS) Act to permit companies to offer and sell securities through “crowdfunding.” Crowdfunding describes the current fund raising technique of soliciting small amounts from many individuals over the Internet for a multitude of personal or social projects, but not in connection with the offer and sale of securities. Title III of the JOBS Act created an exemption under the securities laws to permit crowdfunding to be used to offer and sell a limited amount of securities over the Internet. Although crowdfunding has received a lot of media attention, the proposed rules (consistent with the JOBS Act) contain a number of requirements, limitations and liabilities that may limit its use as a meaningful capital raising alternative for those private companies that would be eligible to use it.

Regulation Crowdfunding (CR)

The SEC’s proposed rules make up a new “Regulation Crowdfunding” that imposes the same requirements, thresholds and limits as Congress set forth in the JOBS Act:

• A company would be able to raise a maximum aggregate amount of $1 million through crowdfunding offerings in a 12-month period;
• Investors, over the course of a 12-month period, would be permitted to invest up to:
• • $2,000 or 5% of their annual income or net worth, whichever is greater, if both their annual income and net worth are less than $100,000; or
  • 10% of their annual income or net worth, whichever is greater, if either their annual income or net worth is equal to or more than $100,000. During the 12-month period, these investors would not be able to purchase more than $100,000 of securities through crowdfunding;
• All crowdfunding offerings will be required to take place through an intermediary like a registered broker-dealer or “funding portal” which is a newly-created form of financial intermediary; and
• The crowdfunding exemption would require companies to file a disclosure statement with the SEC twenty-one days prior to the first sale on new Form C.

Not all companies would be permitted to use equity crowdfunding, including current SEC reporting companies, non-U.S. companies, certain investment companies, companies that are subject to the disqualification provisions of the proposed rules and blank check companies. Investors purchasing securities in a crowdfunding transaction will be restricted from reselling the securities for one year. Also, holders of securities acquired in a crowdfunding transaction would not count against the shareholder threshold that requires companies to register their equity securities with the SEC under Section 12(g) of the Securities Exchange Act of 1934.

Crowdfunding Disclosure Requirements

The proposed rules in Regulation CR would require a company to file certain information on a disclosure statement with the SEC, provide it to the intermediary supporting the crowdfunding offering and make it available to potential investors. Among other things, a company would be required to disclose the following in a crowdfunding offering document:

• a description of the company’s business and the use of proceeds from the offering;
• the price to the public of the securities being offered, 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;
• certain related-party transactions;
• information about officers and directors, as well as owners of 20% or more of the company;
• a description of the financial condition of the company; and
• scaled financial statements of the company that, depending on the amount offered and sold during a 12-month period, would have to be accompanied by a copy of the company’s tax returns (offerings up to $500,000) or reviewed or audited by an independent public accountant or auditor (offerings over $500,000).

Once the offering is completed, the company becomes subject to ongoing reporting requirements. In this regard, it has to provide an annual report to the SEC, posted on its website, that includes updates to its original information disclosure and updated financial statements. This obligation continues until the company becomes an SEC reporting public company, all of the originally issued crowdfunding securities are repurchased, or the company is liquidated or dissolved.

Crowdfunding Intermediary Requirements

Crowdfunding offerings would be conducted exclusively online over the Internet through a platform operated by a registered broker-dealer or a newly-created registered entity, called a “funding portal.” A crowdfunding intermediary that is not a registered broker-dealer must register with the SEC as a funding portal using a proposed Form Funding Portal. Funding portals would be subject to books and records keeping requirements and SEC examinations similar to those that currently exist for broker-dealers. Each crowdfunding intermediary must also register with any applicable self-regulatory organization such as FINRA. Moreover, the SEC will require that a company use a single intermediary for an offering or concurrent crowdfunding offerings in order to maintain a common knowledge of the crowd participants.

These crowdfunding platforms will also be required to provide numerous protections and services to investors, including educational materials, information about the issuer and the offering, and communication channels to permit discussions about offerings on the platform. The funding portal, however, may not offer investment advice or recommendations, solicit purchases, sales or offers to buy securities, compensate employees, agents or other people for such solicitation or based on the sale of securities, or hold, manage, possess or otherwise handle investor funds or securities.

The broker dealer or funding portal intermediary also must provide disclosures to potential investors relating to the risks of crowdfunding and implement procedures to reduce fraud, including:

• forming a reasonable basis for believing that a crowdfunding company is complying with the applicable requirements;
• before permitting an offering through its platform, at a minimum, conducting a background and securities enforcement regulatory history check on the company and its officers, directors and greater than 20% beneficial owners; and
• denying access to its platform to any company that may pose the risk for fraud or otherwise raises concerns regarding investor protection.

FINRA Funding Portal Rules

On October 23, 2013, FINRA proposed rules regarding funding portals and is soliciting public comment through February 3, 2014 on such rules and the related forms for SEC-registered funding portals that become FINRA members pursuant to the crowdfunding provisions of the JOBS Act.

What This Means to You

As these rules are only proposed, companies are not able to begin using crowdfunding to offer and sell equity securities to the public over the Internet. The SEC has made a detailed request for comment on the proposed rules, and the comment period will be open until the end of January 2014. Nevertheless, the burdens imposed by the disclosure and intermediary requirements of Regulation CR, the limits on the amount of the offering and the per investor amount restrictions may limit the use of the equity crowdfunding exemption.

For more information about equity crowdfunding and proposed Regulation CR, please contact Robert B. Murphy (202-906-8721), Mark A. Metz (313-568-5434) or D. Richard McDonald (248-203-0859).

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