Crowdfunding under the JOBS Act

As is common with new laws, commentators, politicians, and business leaders are split as to whether the JOBS Act will be successful. Most agree crowdfunding under Titles II and IV of the JOBS Act will flourish but are more reserved about Title III. Regardless of one’s confidence in the legislation, it has arrived: the SEC proposed its rules for Title III and Title VI in late 2013, while Title II came into effect on September 23, 2013.

An understanding of crowdfunding’s basic concepts is important for investors and small business owners who want to take advantage of the new exemptions. This article provides a general synopsis of the rules, proposed or final, for each type of crowdfunding under the JOBS Act.

Crowdfunding allows entrepreneurs and small business to finance their companies with small contributions of capital from large numbers of individuals instead of using traditional financing methods, i.e., private equity funds, banks, or angel investors.

Historically, crowdfunding has not been used as a means to offer and sell securities because offering a share of a company’s financial returns could trigger the application of the labyrinth of federal securities laws. In response, the JOBS Act created exemptions from the registration requirement and state Blue-Sky laws so this funding method could easily be used to offer and sell securities too. Specifically, Title III was designed to help provide startups and small businesses with capital by making relatively low dollar offerings of securities less costly, while Titles II and IV modified existing rules to effectively allow crowdfunding activities.

Under Section 5 of the Securities Act of 1933 (“33 Act”), an offer or sale of “securities,” i.e., ownership shares of a business, must be registered with the SEC. Recognizing that full registration is not necessary for all securities issuances, the ’33 Act also offers several exemptions from the registration requirement, usually based on the type of security or the nature and size of the transaction.

Section 4(a) (2) of the ’33 Act provides that an issuer of securities does not have to go through the time and expense of a registered public offering in a transaction “not involving any public offering.” Realizing this abstract language needed clarification, the SEC issued Regulation A and Regulation D, a series of rules guiding issuers through the complexities of private offerings.

As will be discussed in this article, the JOBS Act created or expanded three different kinds of “crowdfunding.” First, Title III created the most high-profile provision of the JOBS Act: the new “crowdfunding” exemption, enacted as Section 4(a)(6) of the ’33 Act. See JOBS Act § 302. Second, Title II of the JOBS Act eliminated the ban on “general solicitation and advertising” in connection with offerings made pursuant to Rule 506 of Regulation D under the ’33 Act. See JOBS Act § 201(a)(1). Finally, Title IV of the JOBS Act expanded Section 3(b) of the ’33 Act by requiring the Securities and Exchange Commission (“SEC”) to increase the maximum offering limit under the Regulation A exemption. See JOBS Act § 401(a). These sections can be summarized as follows:

Title III Crowdfunding has received the most attention and specifically allows for “crowdfunding” activities. This provision allows companies to:

Title II Crowdfunding allows companies to raise an unlimited amount of money from an unlimited number of accredited investors using general solicitation and advertising.

Title VI Crowdfunding required the SEC to expand existing Regulation A to permit companies to raise $50 million per year using general solicitation and advertising.

Title III Crowdfunding is what most people think of when they hear “crowdfunding” in the same sentence as “JOBS Act.” And indeed, Section 302 of the JOBS Act expressly required the SEC to permit “crowdfunding” activities.

As it must when offering other securities, a company relying on Title III’s Crowdfunding exemption must comply with numerous requirements, disclosures, and monetary thresholds. Indeed, there are dozens, if not hundreds, of requirements, as evidenced by the nearly 600 pages of the SEC’s proposed rules. The following are some of the most significant:

Title III Crowdfunding transactions must take place through an SEC-registered intermediary, either a broker-dealer or a “funding portal.” A funding portal is an independent online platform for launching crowdfunding offerings, such as ifunding, Patch of Land, or Poliwogg.

Non-U.S. companies, certain investment companies, public-reporting companies, companies that failed to comply with the annual reporting requirements, and other companies disqualified by the rules are not eligible to use Title III Crowdfunding.

Issuers must file a disclosure statement with the SEC at least 21 days prior to its first sale in addition to other financial disclosures, such as audited financial statements for sales over $500,000. Among other things, the offering documents must include:

Issuers are required to file an annual report via EDGAR, the SEC’s electronic database, and provide it to investors.

Legal prospectus liability applies to disclosures, with a “knowledge” exception for misstatements and omissions.

An investor harmed by a material misrepresentation or omission in any of the issuer’s required filing materials is accorded a private right of action.

Due diligence is required of the issuer, including background checks on management and large stockholders.

Investors can change their minds up to two days before the investment deadline and must be given the right to terminate the investment in the event of a material change in the investment opportunity.

The issuer must use new Form C to report its Title III offering.

“Bad actors” are excluded from Title III Crowdfunding.

Likely the most notorious condition of Title III Crowdfunding is the $1 million capital ceiling. While Congress believed $1 million was a substantial amount for small businesses, many commentators and small business owners fervently disagree. Nevertheless, the SEC opted not to recommend an increase and the threshold remains at $1 million.

Significantly, the SEC confirmed that capital procured through other offerings, such as Regulation D or Title II, will not be counted towards the $1 million. Thus, an issuer can complete an offering made in reliance on Title III that occurs simultaneously with, or is preceded or followed by, another exempt offering, such as a Title II offering. Of course, an issuer conducting a concurrent exempt offering for which general solicitation is not allowed must be satisfied that purchasers in that offering were not solicited by means of the Title III offering.

For example, if a prospective investor in a concurrent private placement for which general solicitation is not permitted became interested in that private placement through some means other than the Title III offerings, such as through a substantive, pre-existing relationship with the issuer, then the fact that the Title III offering was posted publicly on the intermediary’s platform would not affect the availability of the other private placement exemption. On the other hand, if an investor first discovered the issuer through a solicitation in a Title III offering, that investor would likely not be eligible to participate in a concurrent private placement in which general solicitation is not permitted. See Crowdfunding, 78 Fed. Reg. 66428 (proposed Nov. 5, 2013) (to be codified at 17 CFR 200, 227, 232, 239, 240, 249).

The second major concern for small businesses is the requirement to provide audited financial statements when raising over $500,000. Before proposing the rules, SEC Chairman Mary Jo White emphasized the SEC wanted the “market to thrive, in a safe manner for investors.” Mary Jo White, Chairman, SEC, Remarks at Open Meeting (Oct. 23, 2013) (transcript available at http://www.sec.gov/News/Speech/Detail/Speech/1370540003082#.U6xlOZRdVyI). Of course, “safe” generally means higher costs for the issuer. As the comment period has ended and the SEC is reviewing the comments, it will be interesting to see if this provision remains unchanged in the final rules.

Outlook. Title III tries to balance two competing interests. On one hand, it gives ordinary people the ability to invest in private deals; while on the other hand, it must protect people from the risks inherent in these types of deals. Title III attempts to create a balance by using the tools of traditional securities laws—disclosure, transparency, reporting, and regulation. Unfortunately, the numerous legal caveats, regulatory boundaries, and procedural hurdles in the SEC’s proposed rules simply might be too much for many small companies to afford.

Many people are confused as to whether raising equity capital through Title III Crowdfunding is the same as crowdfunding under new Rule 506(c). In short, it is not. While Title II of the JOBS Act does not expressly use the term “crowdfunding,” it inevitably permits crowdfunding activities—but to a restricted crowd.

However, because it is a “private placement,” Rule 506(b) prohibits “general solicitation and advertising” to find investors. “General solicitation” is a very broad concept that essentially includes any attempt to create a market for the securities being offered. Thus, an issuer could promote an issuance to an existing customer but could not use the Internet to find more.

To implement Section 201(a), the SEC adopted paragraph (c) of Rule 506. A Rule 506(c) offering, i.e., a Title II Crowdfunding offering, is also exempt from state Blue-Sky registration, but permits an issuer to use “general solicitation and advertising” to raise an unlimited amount of money from an unlimited number of accredited investors, but no unaccredited investors. Like Title III Crowdfunding, “bad actors” are prohibited from using Rule 506(c).

Generally, an “accredited investor” is a natural person who: 1) earned income that exceeded $200,000 (or $300,000 together with a spouse) in each of the prior two years, and reasonably expects the same for the current year; or 2) has a net worth over $1 million, either alone or together with a spouse (excluding the value of the person’s primary residence). An “accredited investor” may also be an entity such as a bank, partnership, corporation, nonprofit or trust, when certain criteria are satisfied.

The JOBS Act requires that issuers wishing to engage in general solicitation take “reasonable steps” to verify the accredited status of purchasers. Rule 506(c) includes a verification method requiring an objective determination by the issuer as to whether the steps taken are “reasonable” in the context of the particular facts and circumstances of each purchaser and transaction. Among the factors that an issuer should consider under this method are:

Rule 506(b) remains unchanged following the adoption of Rule 506(c) and continues to be available for issuers that wish to conduct a Rule 506 offering without the use of general solicitation or that do not wish to limit sales of securities in the offering to accredited investors. Accordingly, there are now two types of offerings available under Rule 506:

Another intriguing issue concerns misstatements and omissions in a company’s advertising materials. Under the ’33 Act, any general solicitation or advertising must not misstate or omit any material information. Thus, companies must make sure its marketing is accurate and truthful, as liability for misstatements still lingers. Now that general solicitation and advertising are permitted, it will be interesting to see how companies overcome the limitations of new technology, e.g., the maximum of 140 characters on Twitter, while satisfying the meticulous securities laws.

Regulation A has always permitted companies to use general solicitation to find investors, but the drawbacks of Regulation A were detrimental to its utility: a company could raise only $5 million; a “mini-registration” statement must be filed by the issuer with the SEC (very expensive); and offerings were subject to state securities laws in every state where the securities were offered. As a result, Regulation A was not used very often.

In response, Section 401(a) of the JOBS Act directed the SEC to relax Regulation A’s requirements. In December of 2013, the SEC proposed its rules which created what is now referred to as “Regulation A+.” Under the rules, Section 3(b)(2) of the ’33 Act will permit:

Regulation A+ offerings are exempt from registration under state Blue-Sky laws.

Of course, Regulation A+ still requires companies to file a “mini-registration” statement with the SEC before any sales are made, including audited financial statements. Moreover, Regulation A+ offerings require significant ongoing reporting to the SEC. Neither Title II Crowdfunding nor Title III Crowdfunding requires a registration statement, mini or otherwise, and Title II is free of most reporting requirements. Nevertheless, the advantages of Regulation A+ could make it appealing for many issuers, particularly with the ability to sell to non-accredited investors.

The Comment Period for the SEC’s Regulation A+ rules closed in March of 2014. The final rules are not expected until early 2015.

In summary, the JOBS Act constructed several new avenues for raising money via the “crowd.” The new legislation lead to substantial changes in the federal securities laws with the goal of providing investors with greater access to the nation’s capital markets. Each method has its benefits and drawbacks, and an issuer should understand the obligations and limitations for whichever approach it selects. One thing is certain, however: Crowdfunding in the securities world has arrived.