This post is the fifth in a series examining the impact of the Jumpstart Our Business Startups Act (or JOBS Act) one year after its passage and focuses on the provisions related to crowdfunding.
Previously in this series, I discussed the progress of implementing the JOBS Act, specifically Titles I and II. In this fifth post, I will continue that discussion by focusing on Title III, which creates a new exemption from the federal securities registration requirement for certain small offerings conducted over the internet, a practice commonly known as “crowdfunding.”
Title III creates a new Section 4(a)(6) to the Securities Act of 1933 exempting offerings up to $1,000,000 on the condition that:
- The aggregate amount sold to any investor by the issuer, including any amount sold in reliance on the crowdfunding exemption during the 12-month period preceding the date of the transaction, does not exceed certain thresholds based upon the investor’s net worth and annual income.
- The transaction is conducted through a broker-dealer or a registered “funding portal” (both of which are considered “intermediaries” under the exemption).
- The issuer complies with other requirements, including that the issuer file with the SEC and provide to investors and intermediaries information about the issuer, including financial statements (which must be certified by the issuer’s principal executive officer, reviewed by an outside accountant, or audited by an outside accountant depending on the size of the target offering amount), the names of its officers, directors, and greater than 20 percent shareholders, a description of the issuer’s business plan, the intended use of proceeds for the offering, the target amount for the offering, the deadline to reach the target offering amount, and a description of the company’s ownership structure. Issuers are prohibited from advertising the terms of the exempt offering, other than to provide notices directing investors to the intermediary. Issuers would also be required to disclose any amounts paid to compensate promoters of the offering through the channels of the broker-dealer or funding portal. Issuers relying on the exemption would need to both file with the SEC and provide to investors, no less than annually, reports of their results of operations and their financial statements as the SEC may determine is appropriate. The SEC may also impose any other requirements that it determines appropriate.
Intermediaries will be required to:
- register with the SEC as a broker-dealer or a “funding portal”;
- register with a self-regulatory authority (most likely FINRA);
- provide disclosures to investors, as well as questionnaires, regarding the level of risk involved with crowdfunding offerings;
- take measures to reduce the risk of fraud, including obtaining background checks from officers, directors, and significant shareholders;
- ensure that all offering proceeds are only provided to issuers when the amount equals or exceeds the target offering amount, and allows for cancellation of commitments to purchase in the offering;
- ensure that no investor has invested in excess of the limits described above;
- take steps to protect privacy of information;
- not compensate promoters, finders, or lead generators for providing personal identifying information of personal investors;
- prohibit the intermediary’s officers, directors, or partners from having any financial interest in an issuer using that intermediary’s services; and
- meets any other requirements that the SEC may require.
Issuers and their officers, directors, partners and other similar controlling persons would have heightened liability for material misstatements or omissions in connection with the offering. Securities sold under the crowdfunding exemption would not be transferable by the purchaser for a one-year period beginning on the date of purchase, except in certain limited circumstances. The provision would preempt state securities laws by deeming securities issued pursuant the crowdfunding exemption “covered securities” (similar to Rule 506 offerings).
In contrast with some of the other provisions of the JOBS Act, there has been next to no activity from the SEC on crowdfunding. Title III itself required the SEC to issue implementing regulations by December 31, 2012. As of May 2013, there are no signs that the rules will be issued any time soon. The SEC has not even proposed preliminary rules (which must go through a comment period prior to the adoption of final rules) as it has with Title II. In addition, after the SEC issues its rules, FINRA will also need to act to create its own rules governing intermediaries. Therefore, it is unlikely that we will have a working crowdfunding exemption prior to 2014 at the earliest.
In addition to timing issues, as I discussed in a previous post, I have concerns that the crowdfunding exemption, as passed by Congress, will turn out to be unusable. As can be seen from my description above, the exemption is very complicated, with significant compliance burdens and liability risks imposed on the issuer and its management. Small issuers will likely find that the cost of professional services necessary to manage this compliance risk may be too high to make conducting a crowdfunding offering worthwhile. It may be possible that funding portals will be able to manage some of this compliance burden for issuers, but by taking on those burdens, it may be that the portals themselves become financially unviable in the long run. In addition, even without all of these compliance burdens, issuers may still find that crowdfunding may be more trouble than it’s worth (see this post for some of the reasons why).
So has my opinion on Title III changed at all in the last year since the passage of the JOBS Act? It has only slightly. I still believe the exemption is significantly more complicated than it needs to be. I also still believe that there are enormous practical problems with any crowdfunding exemption. However, one thing that has struck me over the last year is how much of a hopeful and enthusiastic response the crowdfunding exemption has received from some parts of the startup community. A significant crowdfunding industry has sprung up since the passage of the JOBS Act, consisting of hundreds of startup funding portals dedicated to crowdfunding and numerous associations and conferences. The sheer size of the industry increases the chances that somebody will find a way to make the exemption workable and cost-effective. Of course, with the SEC’s delays in implementing the exemption, this industry remains one without a legal business model. With these continued delays, many startup funding portals may fold due to a lack in revenue, or pivot to other business models, suffocating the enthusiasm that offers a glimmer of hope that we may, one day, see a functioning crowdfunding model in the United States.
 In addition, it is strongly implied by the new Section 4A(a)(8) that the investor limits apply across all issuers. For instance, if an investor’s annual limit is $2,000 per year, that investor could not invest more than $2,000 in crowdfunding in total. Under the JOBS Act, it is the intermediaries who are required to enforce this. It is unclear (though it will likely be clarified in the regulations) what the consequences to the issuer will be for an inadvertent violation of this provision.
 Just about all of the funding portals that currently claim to be up and running are doing one of three things: (1) operating a site that offers kickstarter-type donation-based crowdfunding, (2) operating an online angel investment platform (restricted to accredited investors), or (3) operating illegally.
© 2013 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.