In spite of what you may have heard, the Senate just effectively killed crowdfunding.

This last week, the Senate passed the “JOBS Act,” leaving it one step away from final passage by Congress and Signature by President Obama.  The JOBS Act contains a number of provisions which are aimed at reducing the securities compliance burdens of small companies and startups.  One of the major provisions within the JOBS Act is the so-called “crowdfunding” provision.

Crowdfunding has an enthusiastic following online and within the entrepreneurial community.  Obviously, that following is very excited about the bill’s Senate passage.  Unfortunately, I don’t think they should be popping the champagne corks anytime soon.  Before passing the bill, the Senate passed an amendment to the bill substituting a new version of the crowdfunding law by Senators Merkley, Bennet, and Brown in place of the one written by Rep. Patrick McHenry.  All signs point to the Republican leadership in the House conceding to the Senate’s amendment this week in order to get the bill to the president’s desk for signature as soon as possible.

And I believe the Senate’s amendment kills crowdfunding.  The replacement crowdfunding bill is significantly more complex and fraught with liability for issuers.  While even the McHenry approach had some degree of complexity, the Merkley version makes it look simple and straightforward in comparison.  Here are just a few examples of some of the differences that I think will sink the new crowdfunding law and prevent it from being of any practical use:

  • In the new version, the exemption from registration only applies if the aggregate amount sold to any investor by an issuer (that is, ANY issuer) does not exceed certain caps, which vary depending on the investor’s income.  That’s right, if you use the crowdfunding exemption, it may not apply depending on whether your investors have invested in OTHER startups using the exemption — something you have no control over.  Hopefully, the SEC, in regulations, will provide a safe harbor for issuers to make this determination (both as to income and the amounts invested in other crowdfunding offerings), but you can never count on the SEC making anything simple. [Update 4/19/12: see comments below.  One commenter had pointed out that from first blush the limits may not apply in the aggregate.  However, a separate portion of the bill does confirm that the limits apply in the aggregate, but the funding portal will have the obligation to enforce this.  That said, there still may be significant consequences to the issuer if the funding portal fails to fulfill their responsibilities.]
  • In the new version, the offering can only be made through a registered broker-dealer or a new “funding portal” which also must be registered with the SEC and, apparently FINRA.  In the McHenry version, an issuer could use an unregistered “intermediary” but was not required to.  This additional requirement will greatly increase the costs of conducting a crowdfunding offering.
  • The new version requires that the issuer of any crowdfunding offering of over $500,000 have audited financials, again significantly increasing the compliance costs on issuers.  It also prohibits any advertising to promote the offering.
  • The Merkley amendment creates a new cause of action against a crowdfunding issuer, and its directors and officers.  Traditionally, in Federal securities fraud suits (at least those involving non-public securities), the plaintiff has to prove that the defendant acted knowingly or recklessly.  In any suit involving a crowdfunded company, the burden of proof will be on the defendants and they will need to prove they didn’t know about any misstatements nor in the exercise of reasonable care could not have known about the misstatements.  Good luck finding competent directors for your crowdfunded company.

In all, the statute that provides for the crowdfunding exemption expanded from 12 pages to 24 after the substitution of the Merkley version.  For a crowdfunding exemption to work, it must be simple.  Small companies cannot afford the significant compliance burdens placed upon them by the crowdfunding exemption that was passed.  Therefore, my prediction is that entrepreneurs will quickly find that the new exemption is too expensive to utilize and is more trouble than it is worth and that it will rarely be used.  As I’ve stated in the past, there are some significant practical obstacles to crowdfunding even with the McHenry bill.  The Senate’s solution certainly didn’t help.   Therefore, I believe the Senate may have just effectively killed crowdfunding.  I may be wrong; the SEC may implement the bill well through regulation and save crowdfunding.  Anyone want to take a bet that this happens?


© 2012 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

Alexander J. Davie About Alexander J. Davie

Alexander Davie is a corporate and securities attorney based in Nashville, Tennessee. Businesses of many varieties rely on his counsel and judgment throughout all stages of their growth. In particular, fund managers and investment management professionals seek the expertise Alex gained when he served as general counsel to a private investment fund. Alex also has significant experience and enjoys working with companies and entrepreneurial ventures, especially within the technology industry. As a believer in technology's ability to enrich people's lives and allowing people to connect with each other in new ways, he is passionate about helping tech startups achieve success. He is active in Nashville's startup community as a mentor at the Nashville Entrepreneur Center and participates in numerous other events geared towards making Nashville a nationally ranked location for starting a business.

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  1. You count pages differently than do I – SA 1884 occupies just over 2 pages of the Federal Register. A nit.

    As to the funding limits, I do not read the provisions of section 302 the same way you do. I hope you’re reading it wrong, but can’t say for sure. It says an exemption will exist as to:

    transactions involving the offer or sale of securities
    by an issuer ... provided that:
    (A) the aggregate amount sold to all investors by
    the issuer [in this year] is not more than $1,000,000;

    (B) the aggregate amount sold to any investor by
    an issuer [in this year] does not exceed -
    [income or net worth based limits]

    I read “the aggregate amount sold to any investor by an issuer” to refer to the issuer of the present security. That is, I read “an” to be like “the”. You are reading “an” to be like “any”. I have not listened to any floor debate on this, but I hold out hope that Merkley meant “the”. Perhaps the House will vote this down and send it to reconciliation to clarify.

    I do not disagree that the Merkley amendment creates a ton of headaches. There is a hard limit on the exemption to $1mm/year _from all sources_, so crowdfunding is out for capital-intensive startups regardless of whether it was going to be part or all of the capital-raise activity. The ask must be through an intermediary, and the requirements on them are silly. It mandates (not just permits) additional SEC regulation on every aspect of crowdfunding. It puts reporting requirements on all issuers, no matter how small.

    Worse, the hope you hold out that the SEC will save this is likely misplaced, because the amendment guts the SEC’s flexibility in rule-making. For instance, the only thing the SEC can do to change the issuer reporting requirements is _lower_ (not raise) the floor for the requirement that financials be audited.

    Who is Merkley helping or protecting with this? His public statement on the amendment rings hollow, and provides little information: he says he was trying to protect the crowdfunding marketplace from itself, and suggested that people would not fund if they did not have government vouching for the quality of the investments. Experience has not bourne that out.

  2. Matt,

    Agreed that the word “an” may not mean “any” but the same “the” in the previous section. Hopefully that is the interpretation that the SEC takes. I remember reading Scott Walker’s piece on the Merkley amendment a while back and I think that biased my thinking. Here’s a link to his piece where he seems to be taking the opinion that the “an” is an “any”:

    I do think the SEC has the power to make things easier for investors. Rule 506 is a good example of this. The Supreme Court has held that 4(2) offerings need to be made to sophisticated persons. Rule 506 provides a safe harbor for this by using net worth to approximate sophistication. But really, some high net worth individuals may not have business sophistication (celebrities, people who won the lottery, people who inherited money). Of course that doesn’t mean the SEC will make things easier.



  3. [sorry. posted twice because i forgot to check the ‘notify me’ box]

    Thanks for your article. I’ve been reading about the JOBS Act and most postings are about the crowdsourcing options. But it seems like there are additional tax benefits and other helpful points. Correct? Apart from that I’m curious as to raising funds apart from crowdsourcing.

    First, I believe the JOBS Act will change many things. And I see it on two fronts since I have two businesses – one as a brander/marketing where I work with mostly small business people and another as a music composer/producer. (I also work with small business people!) The JOBS Act affects me in both industries. I already have clients interested in getting their business plans dusted off. As a composer, I have retained my full rights to a now sizable catalog of industrial music that I plan on licensing. It’s well over 2000 pieces made up of award-winning themes, beds, bumpers and cues – perfect for any video you see on TV or online.

    With this new JOBS Act, I was wondering if I could use this catalog as a sort of interest bearing fund. I figure that most people have a few thousand dollars in the bank earning basically nothing. I wanted to put together an offering and bring in money to finance the marketing and promotion of my library and acquire even more music. I am certain the return on the publishing will be better than any CD or bank savings rate.

    But all I read about is the crowdsourcing option. Can I raise money now – direct to people – with my model? 100 people with $1000 to $5000 each would work wonders for my business. What about putting a post on my Facebook page, a YouTube video? (i.e. “Do you have a few thousand dollars sitting in a CD or savings account earning almost zero? How about investing in music and earning more?) I wish there was information on that sort of thing. Of course, it’s all new. Thanks

  4. Michael,

    All of these are good questions.

    There are no tax benefits to using the new crowdfunding exemption. It is an exemption from securities registration and does not affect taxation.

    As I discussed in my article, I’m not very optimistic about the new crowdfunding exemption. I don’t think that many startups would find it very useful. You mentioned posting a facebook page or a YouTube video. It remains to be seen how the SEC will implement it through regulations. We do know that you would be prohibited from any public posts about the offering except one that directs a potential investor to a “funding portal.” Do the post that you used as an example would probably be prohibited.

    Also, you asked if you could use the crowdfunding exemption now. The answer is no. It will take some significant time for the SEC to produce implementing regulations and then the funding portals will need to be created. I don’t anticipate anything happening until late 2013 at the earliest.


  5. Thanks for the reply. It’s a bummer to think that this one thing could have so much potential but probably end up mired in red tape and insignificance. If the best ORIGINAL intentions of JOBS Act were allowed, I think it could be the single greatest catalyst for creating a new and healthier economy. It would create new business, jobs, bring opportunities for wealth to the common man and equalize the banking system (i.e., instead of the bankers making loans, the individual would be empowered to engage directly.)

    And if you think about the stock market, funds, non-profits and political contributions – why are they the sacred calves? It’s wrong. The everyday person can put their money into a company whose leaders they will never know but can’t easily put it into the pockets of a neighbor whose new business idea COULD directly affect that community. Both are investing in business. / Then what about “giving” to Kickstarter or political campaigns? Giving versus investing? WTF is the difference? If I give $5 contribution or a $5 investment or a loan, it’s regulated completely differently. Now, I do believe in federal/state regulation at some levels, but this is an area where the market should truly be freed IMMEDIATELY. There is money just sitting there. Doing NOTHING. Not even earning decent interest (savings, CDs.)

    I WAS excited but now I’m discouraged. It could have been the most positive “affect Main Street, the country and then the world” law in decades. But no, it would have really hurt banks and Wall Street since I could foresee people making a run on banks and putting their money where they wanted too and making more than “zero” interest! Why can’t the politicians just do something that actually matters and is the right thing to do for the middle class?

    It perpetually sucks.

  6. Matt,

    I finally got a chance to look into the issue of whether the investment limits are in the aggregate or per issuer. It appears they are in the aggregate. See section 4A(a)(8) which reads that an intermediary must “make such efforts as the Commission determines appropriate, by rule, to ensure that no investor in a 12-month period has purchased securities offered pursuant to section 4(6) that, in the aggregate, from all issuers, exceed the investment limits set forth in section 4(6)(B)”.

    So the bad news is that the limits do apply in the aggregate. The good news is that the onus does appear to be on the funding portal and not the issuer. That said, it is not 100% clear that if the funding portal gets it wrong, that the issuer will not face strict liability for selling unregistered securities or for blue sky violations as a result of the loss of the covered security designation. In addition, we have no idea what due diligence requirements the SEC will place upon the funding portals. If they are significant, the costs will be passed onto the issuer in the form of higher fees.

    • Unfortunately, I now agree with your reading. There is technically some wiggle-room yet: the SEC could determine that the requirement on intermediaries is to analyze the behavior of issuers in the aggregate. That is to say, a permissible reading of the two sections together is that 4(6)(B) means an issuer cannot sell more than $2000 to a single investor “in the aggregate” (meaning across issuances in the same 12-month period), and the new 4A(a)(8) means that the intermediary must check that no issuer sold more than $2000 to a single investor in any 12-month period. In fact, my naive and optimistic reading of the section was precisely that, reading “from all issuers” as an independent clause that could be moved without change of meaning to the beginning or end of the sentence. But I now find that reading to be a stretch, and in any event far-fetched: the SEC has never backed away from an opportunity to regulate for the perceived protection of investors, and will not do so here.

      I also think the SEC is likely to put the onus on both the issuer and the funding portal. I read 4(6)(B) to eliminate the exemption if the investment limits are exceeded. This might be analogous to a determination that the investors to whom the issuer sold securities claiming an exemption under Rule 506 were not accredited when they were required to be. At least as to that investor, the issuer may have liability at a minimum to undo the investment.

      We’ll see what the SEC does with all of this, but I do not have great hopes.

  7. Gold Miner. Jr says:

    Considering offerng an ounce of gold from my mine that is gearing up to recommence production for any one contributing $1000.00. As price of gold today is $1600+ that is a significant premium. Does this enter the field of crowdfunding, securities, or ??????

    • Probably. If the deal is: invest cash now in a venture and expect profit in the future (delivered in gold), then it’s an investment contract and thus a security.

      Whether a deal like this is permissible under crowdfunding will be largely dependent on the regulations that the SEC issues.

      Finally, I’m not an expert in commodities regulation, but your proposed arrangement may also fall under commodities futures regulation.

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