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SEC Proposes JOBS Act Crowdfunding Rules11월 11, 2013
On October 23, 2013, by unanimous vote, the SEC proposed new rules to permit the offer and sale of securities through internet crowdfunding without Securities Act registration (Regulation Crowdfunding).
Regulation Crowdfunding expands the potential of crowdfunding as an alternative source of capital raising and further enables new fundraising platforms by establishing a crowdfunding fundraising regulatory infrastructure subject to significant federal oversight.
The proposed rules seek to implement Title III of the Jumpstart Our Business Startups Act (“JOBS Act”). The full text of the proposing release is available here. Title III and other provisions of the JOBS Act are explained fully in our JOBS Act client alert, available here.
In addition, in connection with Regulation Crowdfunding, on October 23, 2013, FINRA proposed rules to govern funding portals. A more in-depth discussion of FINRA’s proposed rules may be found here.
Comments are due on Regulation Crowdfunding by February 3, 2014.
Regulation Crowdfunding -- Overview
Section 4(a)(6) of the Securities Act provides an exemption from the registration requirements of Section 5 for certain crowdfunding transactions. To qualify for the exemption, crowdfunding transactions by an issuer must meet the following requirements.
Certain companies are not eligible for the exemption, including issuers who: (i) are formed outside of the United States; (ii) are subject to Exchange Act reporting requirements; (iii) are investment companies, or companies excluded from the Investment Company Act pursuant to Sections 3(b) or 3(c); (iv) subject to disqualification provisions under Regulation Crowdfunding; (v) failed to comply with the annual reporting requirements of Regulation Crowdfunding; and (vi) blank check companies.
Issuer Total Offering Amount Limitation -- $1 Million During Any 12-Month Period
Issuers are limited to raising not more than $1 million in any 12-month period under the new crowdfunding rules. In calculating this amount, issuers need not take into account capital that has been raised without the offer and sale of securities (i.e., donations, gifts, grants, or loans) or capital raised pursuant to another valid exemption (i.e., offerings pursuant to Rule 506(c) of Regulation D).
However, in calculating the total amount raised during any 12-month period, an issuer must include any offerings made pursuant to the crowdfunding regulations by other issuers that control, are controlled by, or are under common control with the issuer.
Total Investment Amount Limitation
Regulation Crowdfunding expressly limits the total amount that each investor may invest in any 12-month period. Specifically, investors are limited to investing, in all Regulation Crowdfunding offerings during any 12-month period:
- the greater of $2,000 or 5 percent of the investor’s annual income or net worth,1 if the annual income or net worth of the investor is less than $100,000; or
- the greater of 10 percent of the investor’s annual income or net worth (not to exceed an amount sold of $100,000), if the investor’s annual income or net worth is $100,000 or more.
Pursuant to proposed Rule 100 of Regulation Crowdfunding, issuers may rely on intermediaries to determine that individual investors are not exceeding these limits.
Required Use of an Intermediary
Regulation Crowdfunding requires that any crowdfunding transaction be conducted exclusively through an intermediary that is registered as either a broker-dealer or as a funding portal.2 In addition, Regulation Crowdfunding requires that an issuer only use one intermediary during any particular crowdfunding transaction.
Offering Disclosure Requirements
An issuer seeking to engage in a crowdfunding transaction under Regulation Crowdfunding must file certain disclosures with the SEC on new Form C at the time of the crowdfunding transaction, and provide such disclosure to its intermediary and prospective investors, including information regarding the issuer’s:
- officers, directors, and greater than 20% shareholders;
- business and business plan;
- use of proceeds;
- target offering amount, price of securities, and method of determining price; and
- ownership and capital structure.
Regulation Crowdfunding would also require issuers to:
- identify the crowdfunding intermediary and disclose any compensation paid;
- include certain legends in the offering document;
- disclose the issuer’s current number of employees;
- discuss material risk factors that make investments in the issuer speculative or risky;
- describe the material terms of any indebtedness of the issuer;
- disclose any other exempt offerings during the last three years;
- disclose certain related party transations.
In addition, issuers are required to file with the SEC and provide to intermediaries and prospective investors certain information regarding the issuer’s financial condition. The type of information that must be provided is dependent upon such issuer’s aggregate target offering amounts under the crowdfunding exemption within the preceding 12-month period:
- for offerings of $100,000 or less -- tax returns filed for the most recently completed year (if any) and a certification of the principal executive officer that financial statements are true and complete.
- for offerings between $100,000 - 500,000 -- financial statements reviewed by an independent public accountant.
- for offerings of more than $500,000 -- audited financial statements prepared by an independent public accountant.
Finally, issuers are required to file with the SEC regular updates on the issuer’s progress in meeting the target offering amount, no later than 5 days from certain set intervals, on new Form C-U.
Restrictions on Communications
As mandated by the JOBS Act, an issuer conducting a crowdfunding transaction may not advertise the terms of the offering outside of the broker or funding portal facilitating the offering. An issuer may, however, publish notices of the offering that include:
- a statement that the issuer is conducting an offering;
- the name of the intermediary;
- a link to the intermediary’s online platform;
- certain limited terms of the offering, including (i) the amount of securities offered; (ii) the nature of the securities; (iii) the price of the securities; and (iv) the closing date of the offering period; and
- factual information about the legal identity and business location of the issuer.
In addition, issuers are prohibited from providing compensation to persons who promote the offering, unless the issuer takes reasonable steps to insure that the promoter clearly discloses the receipt of this compensation each time the promoter makes a promotional communication.
Securities purchased in an offering conducted pursuant to Regulation Crowdfunding may not be resold for a period of one year unless such securities are sold or transferred:
- to the issuer of the securities;
- to an accredited investor;3
- as part of a registered offering; or
- to a family member in connection with the death or divorce of the investor.
Following the one-year holding period, securities purchased in an offering conducted pursuant to Regulation Crowdfunding will no longer be restricted securities and are freely transferrable by the investor.
Annual Reporting Requirement
An issuer who has conducted an offering pursuant to Regulation Crowdfunding will be required to file annual reports with the SEC on new Form C-AR, and to post such reports on its website. The disclosure contained on new Form C-AR will closely mirror the disclosure provided to investors during the crowdfunding offering, and will be due within 120 days after the end of the issuer’s fiscal year. Issuers will be required to continue filing annual reports on Form C-AR until the earliest of one of the following:
- the issuer becomes an Exchange Act reporting company;
- the issuer repurchases all of the securities issued pursuant to the crowdfunding exemption; or
- the issuer liquidates or dissolves in accordance with state law.
Under Regulation Crowdfunding, an issuer would be required to file new Form C-TR to disclose that its reporting obligations have been terminated.
Regulation Crowdfunding provides a safe harbor for insignificant deviations from a term, condition, or requirement of the proposed rules. To qualify for the safe harbor, an issuer must demonstrate that:
- the issuer’s failure to comply was insignificant with respect to the offering as a whole;
- the issuer made a good faith and reasonable attempt to comply with the requirements of the crowdfunding rules; and
- the issuer did not know of the failure to comply, where the failure to comply with a term, condition or requirement was the result of the failure of the intermediary, or such failure by the intermediary occurred solely in offerings other than the issuer’s offering.
Regulation Crowdfunding -- Intermediaries
Regulation Crowdfunding requires that any crowdfunding transaction conducted by an issuer be made through an intermediary (i.e., a registered broker-dealer or funding portal). The following provides a brief overview of the requirements for intermediaries.
The proposed Form Funding Portal requires information about the funding portal’s place of business, its legal organization, business activities, control affiliates, and the portal’s website or means of access, among other things. The Form must be amended within 30 days of becoming inaccurate for any reason, and funding portals must file a withdrawal of registration upon ceasing to operate as a funding portal. Similar to Form BD, most of the information provided to the SEC on Form Funding Portal would be made publicly available.
Funding Portal Exemption from Broker-Dealer Registration
Crowdfunding intermediaries (whether a broker-dealer or a funding portal) must register with the SEC and with FINRA, but need not register as an exchange or as an alternative trading system. For funding portals who register as such with the SEC, the proposed rules provide a non-exclusive, conditional safe-harbor from the broker-dealer registration requirements of the Exchange Act. Under the proposed safe-harbor, a funding portal may not engage in the activities prohibited under Section 3(a)(80) of the Exchange Act, but may:
- limit offerings made through its platform based on eligibility requirements;
- highlight and display offerings on its platform;
- provide communication channels for potential investors and issuers;
- provide search functions on its platform;
- advise issuers on the structure or content of offerings;
- compensate others for referring persons to the funding portal and for other services;
- advertise the funding portal’s existence;
- deny access to certain issuers based on potential fraud or investor protection concerns;
- accept investment commitments; and
- direct the transmission of funds.
Additional Requirements for Funding Portals
Funding portals are also subject to certain specific requirements. Funding Portals must:
- have in place, and must maintain, a fidelity bond that has a minimum coverage of $100,000 and covers associated persons of the portal;
- implement policies and procedures that are reasonably designed to achieve compliance with the federal securities laws;
- comply with anti-money laundering provisions as set forth in the Bank Secrecy Act;
- comply with Regulation S-P (Privacy of Consumer Financial Information and Safeguarding Personal Information), Regulation S-AM (Limitations of Affiliate Marketing), and Regulation S-ID (Identity Theft Red Flags);
- create and maintain certain records for a minimum of five years, including records of (i) investors and notices or confirmations provided to investors; (ii) information about issuers using the platform; (iii) all communications occurring on or through the platform; (iv) compliance with the requirements of the crowdfunding rules; (v) all written agreements entered into by the funding portal; (vi) monthly and quarterly summaries of transactions effected through the portal; (vii) each securities offering; (viii) organizational documents; and (ix) those records required to be kept pursuant to the Bank Secrecy Act.
Obligations of Intermediaries in Crowdfunding Offerings
Regulation Crowdfunding requires intermediaries to undertake certain actions before and during their participation in crowdfunding transactions, including, but not limited to:
- prohibiting their directors, officers, and partners from having any financial interest in an issuer that is using the intermediary, including the receipt of a financial interest in the issuer as compensation for the services provided in the offer and sale of the issuer’s securities;
- having a “reasonable basis” for believing that the issuer is in compliance with the securities laws and has established a means to keep accurate records of holders of the securities it offers (for this purpose, an intermediary may rely on issuer representations, absent reason to believe to the contrary);
- denying access to the online platform if, at any time, the intermediary has a reasonable basis to believe that an issuer is subject to a disqualification;
- conducting background and securities compliance checks on the issuer, and the issuer’s officers, directors, and 20% or more shareholders;
- not accepting an investment commitment unless the investor has opened an account with the intermediary and the intermediary has obtained the investor’s consent to electronic delivery of materials;
- providing investors, at the time the investor opens an account, certain plain-language educational materials including mandated information, and updating these materials as necessary;
- requiring each investor to answer questions demonstrating the investor’s understanding that there are restrictions on the ability to cancel an investment commitment, and that it may be difficult for an investor to resell the securities;
- making certain information provided by the issuer publicly available on the platform for a minimum of 21 days before any securities are sold; and
- having a reasonable basis to believe that investors satisfy the investment limitations of the crowdfunding regulations (intermediaries may rely on an investor’s representations, absent reason to believe to the contrary).
Intermediaries that are registered brokers must also comply with established requirements for the maintenance and transmission of investor funds. However, as funding portals cannot receive any funds, they must direct investors to transmit money directly to a qualified third party to hold the funds for the benefit of the investors, and must promptly direct the third party to transmit the investor funds to the issuer when the offering is completed.
If there is a material change to the terms of an offering, intermediaries must send potential investors notice of the material change, stating that the investment commitment will be cancelled unless the investor reconfirms the commitment within five business days of receipt of the notice. If the investor does not reconfirm the commitment within the five business days, the intermediary must: (i) send the investor notice that the commitment was cancelled, stating the reason for the cancellation and the refund that the investor should expect to receive; and (ii) direct the refund of investor funds.
Finally, intermediaries can only transmit offering proceeds to an issuer if the target offering amount is met or exceeded. If an issuer does not complete an offering, intermediaries must, within five business days: (i) send notice to each investor disclosing the cancellation of the offering, the reason for the cancellation, and the refund amount that the investor should expect to receive; (ii) direct the refund of investor funds; and (iii) prevent investors from making investment commitments with respect to that offering on its platform.
Section 4A(c) provides that an issuer who conducts a crowdfunding offering will be liable to a purchaser of its securities if, in the offer or sale of the securities, such issuer (i) makes an untrue statement of a material fact or (ii) omits to state a material fact required to be stated or necessary in order to make the statements, in light of the circumstances under which they were made, not misleading; provided, however, that the purchaser does not know of the untruth or omission, and the issuer is unable to prove that it did not know, and in the exercise of reasonable care could not have known, of the untruth or omission.
As Section 4A(c)(3) defines an issuer to include “any person who offers or sells the security in such offering,” such liability provisions likely apply to intermediaries, including funding portals. However, the SEC stated that it believes that intermediaries may take certain steps in exercising reasonable care, such as establishing policies and procedures that are reasonably designed to achieve compliance with the requirements of Regulation Crowdfunding, or 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.
 “Net worth” is to be calculated in accordance with Regulation D.
 Section 3(a)(80) of the Exchange Act defines a funding portal as any person acting as an intermediary in a crowdfunding transaction that does not: (i) offer investment advice or recommendations; (ii) solicit purchases, sales, or offers to buy the securities displayed on its platform or portal; (iii) compensate employees, agents, or other persons for such solicitation or the sale of securities; or (iv) hold, manage, process, or otherwise handle investor funds. In most instances, the proposed rules also apply to the associated persons of brokers and funding portals. Crowdfunding intermediaries that are not already registered broker-dealers must register with the SEC as a funding portal by filing the proposed Form Funding Portal.
 “Accredited investor” is defined in accordance with Regulation D.
If you have any questions regarding this client alert, please contact any of the lawyers in the Capital Markets Group listed below.
C. Brophy Christensen
Michael J. Schiavone
This memorandum is a summary for general information and discussion only and may be considered an advertisement for certain purposes. It is not a full analysis of the matters presented, may not be relied upon as legal advice, and does not purport to represent the views of our clients or the Firm. Rob Plesnarski, an O'Melveny partner licensed to practice law in the District of Columbia and Pennsylvania, Bjorn Hall, an O'Melveny counsel licensed to practice law in the District of Columbia, and James Harrigan, an O'Melveny associate licensed to practice law in the District of Columbia and Maryland contributed to the content of this newsletter. The views expressed in this newsletter are the views of the authors except as otherwise noted.
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