Crowdfunding: Using the Internet to Raise Small Business Capital
For several years entrepreneurs have looked forward to the day when they could freely raise capital for emerging businesses over the internet without having to register the securities with federal or state securities regulators. The recently adopted Jumpstart Our Business Startups Act (“JOBS Act”) provides a statutory structure for how this may be done, but it cannot be used until the Securities and Exchange Commission (“SEC”) adopts enabling rules, the scope and nature of which cannot now be predicted with any degree of confidence.
Congress has now passed, and the President has signed, the JOBS Act,1 which will allow emerging businesses to raise capital over the internet. That Act directs the SEC to revise its rules relating to offerings made in reliance upon the private offering safe harbor afforded by Rule 506 of Regulation D under the Securities Act of 1933 to provide that the prohibition against general solicitation or general advertising not apply to offers and sales of securities made pursuant to Rule 506, provided that all purchasers of the securities are accredited investors.2 This rule revision would allow such offerings of any size to be made over the internet by emerging businesses directly to accredited investors. That Act also amends the Securities Act of 1933 to allow small businesses to raise capital from the general public (“crowdfunding”)3 in small amounts through an internet intermediary registered with the SEC and an applicable self-regulatory agency.4 The intermediary may be either a broker or an internet “funding portal.”5
The Act directs the SEC to revise its rules relating to Rule 506 offerings within 90 days of the date of enactment of the Act and to adopt enabling rules for crowdfunding within 270 days of that date. Thus, small businesses cannot legally raise capital over the internet under this new legislation until the SEC rulemaking process has been completed, and the SEC’s work backlog is currently such that it may not meet the rulemaking deadlines Congress established under the statute.6 Raising capital over the internet before the SEC rules have been promulgated could lead to sanctions by state or federal securities regulators, which might disqualify the violator for up to ten years from being associated with a business that seeks to raise capital through either Rule 5067 or crowdfunding.8
Crowdfunding may only be used by companies that are organized under and subject to the laws of a State or territory of the United States or the District of Columbia and is not available to one that is already a reporting company under the Securities Exchange Act of 1934 or is an Investment Company under the Investment Company Act of 1940 (or is excluded from the definition of investment company by virtue of Section 3(b) or Section 3(c) of that Act).9 A crowdfunding investor is limited to an aggregate investment during any 12 months period in all crowdfunded companies of an amount determined by a formula based upon the particular investor’s net worth and annual income, which allows maximum investments of from $2,000 to $100,000.
The crowdfunding provisions of the JOBS Act are complex and leave significant aspects to clarification and refinement by the SEC. One such aspect is the relationship between financings in reliance upon Rule 506 and those using crowdfunding. The crowdfunding provisions limit the amount a business may raise for 12 months before and during a crowdfunding transaction to $1 million,10 which for a rapidly growing small business may be inadequate. Another provision states that a company may raise capital by methods other than crowdfunding,11 but how this relates to the $1 million crowdfunding limit is not clear. Unless the SEC clarifies and resolves this by rulemaking, if a business were to raise additional amounts of capital over the internet in reliance upon Rule 506, either before or after a crowdfunding round, it would have to wait for six-months12 in order not to risk destroying both the Rule 506 offering and the crowdfunding offering by virtue of the “integration doctrine,” which would deem both offerings part of a single offering. The Rule 506 internet offering would be disqualified because it may be made only to accredited investors, and integration with the crowdfunding offering would cause the small non-accredited crowdfunding investors to become part of the Rule 506 offering. And the $1 million in 12 months crowdfunding offering limit might well be exceeded if the Rule 506 offering were integrated with the crowdfunding one. So, unless the implementing SEC rules successfully resolve this dilemma, careful planning should surround any use of crowdfunding as a financing strategy lest alternative financing options be curtailed when they may be most needed. This is in addition to the “off-putting” effect upon professional venture capital and angel investors that a company with a multitude of small unsophisticated shareholders would have in the aftermath of a crowdfunding round, even if the company were to demonstrate significant early success in its business operations.13
State securities regulators have since 1996 been preempted by federal law from registering under state securities laws14 securities offered in reliance upon Rule 506, and the JOBS Act preserves this and also preempts state regulators from doing so with respect to the securities of businesses offered by means of crowdfunding. However, in both cases the enforcement authority of state securities regulators with respect to “fraud or deceit” (i.e., misdisclosures) is expressly preserved,15 so disclosure is likely to be an area of scrutiny by state securities regulators, particularly in the wake of investor complaints, which are expected to be numerous following business failures of crowdfunded startup businesses. In this regard, statistically most business startups fail within a few months, and it is questionable the extent to which small crowdfunding investors will realistically appreciate this risk, despite disclosures, until their investment has been lost in its entirety, at which point they can be expected to complain to state regulators for help.
The crowdfunding provisions of the JOBS Act refer briefly to certain disclosures that a small business must make in a crowdfunding offering, including a description of the company’s business and business plan, certified, reviewed or audited financial statements (depending upon the amount of funds to be raised), use of proceeds, the past or prospective compensation received by persons to promote the offering through the intermediary’s channels,16 the method for determining the offering price of the securities, ownership and capital structure, and risks to investors relating thereto.17 But these references in the JOBS Act only indicate the subject matter of certain disclosures and are neither comprehensive nor detailed. Securities offering disclosures have been developed and refined by securities laws professionals and regulators over the almost 80 years during which the Securities Act of 1933 has been in effect, and it is unlikely that inexperienced small business owners will be able to prepare a balanced and complete set of disclosures without more detailed guidance. The JOBS Act does not by its terms establish a mechanism for preparation of the disclosures by securities professionals or others, and it remains to be seen whether the SEC will try to do so by rule if the statute does not contemplate it.
While the bills that became the JOBS Act were pending in Congress, a committee on small business capital formation of the North American Securities Administrators Association (“NASAA”), the trade association for state securities regulators, developed a proposed Model Crowdfunding Exemption for state securities regulators to use in crowdfunding offerings if the federal crowdfunding legislation did not preempt state regulation. The Washington securities administrator is a member of that committee. Attached to that proposed Model Crowdfunding Exemption was a fill-in-the-blanks disclosure document modeled after NASAA’s Form U-7 question-and-answer disclosure document for state registration of small offerings that are exempt from federal regulation under Rule 504 of Regulation D. Form U-7 was initially developed by the Washington Securities Division.18 The assumption is that filling in a detailed questionnaire has a better chance of evoking adequate disclosure by a small business than does freewriting. Because the states have been preempted by the JOBS Act, NASAA’s proposed Model Crowdfunding Exemption and its fill-in-the-blanks disclosure document will presumably never be adopted. However, the SEC’s Offering Circular Model A to its Form 1-A Offering Statement under Regulation A is a question-and-answer disclosure document that is modeled upon and virtually identical to NASAA’s Form U-7, and it is possible that in implementing the crowdfunding provisions of the JOBS Act the SEC may reference its Offering Circular Model A as a suggested disclosure aid to crowdfunding issuers.
In any event, under the general antifraud provisions of federal and state securities laws,19 disclosures in connection with the offer and sale of securities must be accurate and complete in all material respects. Any guideposts by the SEC to assist in this should reduce later problems when business failures become manifest. Despite broad language in the JOBS Act providing investors with civil remedies in the event of misdisclosures,20 the amounts raised in crowdfunding offerings will be too small for investors to economically recover their investments through civil litigation after business failure, irrespective of the egregiousness of the disclosure defects, and thus these civil remedy provisions of the Act are largely illusory as a practical matter. Accordingly, the practical risks for misdisclosure in crowdfunding offerings will be administrative actions by federal or state securities regulators, which could lead to disqualification of the persons involved from being associated with companies undertaking Rule 50621 or crowdfunding22 offerings for up to ten years – a result which could substantially compromise those persons’ careers.
The JOBS Act regulation of the intermediaries through which crowdfunded securities are to be offered substitutes the intermediaries for securities regulators as “gatekeepers” in the offerings. In addition to registering with the SEC and any applicable self-regulatory organization,23 the crowdfunding intermediary will have to take “measures to reduce the risk of fraud,” including obtaining a background and securities enforcement regulatory history check on each officer, director, and person holding more than 20% of the outstanding equity securities of the crowdfunding small business.24 The background check should include criminal history in order to confirm that the company is not disqualified from using the crowdfunding mechanism. The problem is that, although at least one commercial data company will now provide a 50-state criminal check for roughly $40 per person, a 50-state securities enforcement regulatory history check is not currently available to the public through a commercial data company at any price. Presumably, between now and the time the SEC adopts rules implementing crowdfunding under the JOBS Act, one or more commercial data companies will be able to provide a 50-state securities enforcement regulatory history check at a price that will be acceptable to crowdfunding intermediaries.
Crowdfunding intermediaries: must make available to the SEC and to potential investors not later than 21 days prior to the first day on which crowdfunded securities are sold the disclosures by the company engaged in the crowdfunding offering,25 must ensure that all offering proceeds are provided to the company only when the aggregate capital raised from all investors is equal to or greater than a target offering amount, must allow investors to cancel their commitments to invest,26 and must make efforts to ensure that no investor in a 12-months period has purchased securities that in the aggregate from all crowdfunding companies exceeds the applicable investments for that particular investor,27 all in accordance with SEC enabling rules. One rather quirky provision of the JOBS Act requires that an intermediary ensure that each investor “answer questions demonstrating” an understanding of the level of risk applicable to investing in startups and associated investment illiquidity,28 which literally seems to suggest that investors be required to take some sort of test – presumably the SEC will clarify this in its enabling rules.
Fortunately, securities sold through the crowdfunding process will not be counted as “held of record” by investors in the crowdfunding company for purposes of precipitating registration with the SEC under Section 12(g) of the Securities Exchange Act of 1934,29 which would otherwise trigger all of the periodic reporting, proxy, tender offer, short-swing profits recovery and other provisions regulating public companies under that Act. Despite the apparent efficiencies that might be involved, funding portal intermediaries may not serve as intermediaries in the resale of crowdfunded securities held by the investors after the crowdfunded offering without registering as a broker-dealer under federal and state securities laws, as the JOBS Act only provides an exemption from broker-dealer registration for the initial crowdfunding offering on behalf of the companies themselves. In any event, the securities would have to be held by the investor for one year unless resold or transferred to the company, an accredited investor, or a family member, or as the result of death or divorce.30 The securities held by the new shareholder upon any such resale or transfer would then presumably be counted as “held of record” for purposes of Section 12(g).31
The crowdfunding provisions of the JOBS Act have several provisions designed to discourage an attempt to sell a company’s shares by use of hype that circumvents the official offering disclosures made through the crowdfunding intermediary. For example, an intermediary must not compensate promoters, finders or lead generators for providing the intermediary with the personal identifying information of any potential investor,32 must take steps to protect the privacy of information collected from investors,33 and it must prohibit the intermediary’s directors, officers, or partners from having any financial interest in the company being crowdfunded,34 And a funding portal intermediary may not offer investment advice or recommendations, may not solicit purchases, sales or offers to buy the securities, and may not compensate employees, agents or other persons for such solicitation or based upon the sale of the securities.35 Further, a crowdfunding company may not advertise the terms of the offering, except for notices which merely direct investors to the intermediary.36
In conclusion, despite the desire to get out ahead of the crowd and exploit as soon as possible the new fundraising potential of Rule 506 offerings and crowdfunding over the internet, one must refrain from doing so until the SEC has adopted the enabling rules so the details of what will be involved may be reviewed and complied with. To proceed prematurely would risk precipitating administrative action that could hamper or even preclude using either approach in the future. The Washington Securities Division is concerned about entrepreneurs and intermediaries jumping the gun on crowdfunding, and NASAA is apparently developing some messaging on this. On March 20, 2012, the Massachusetts Securities Division brought an administrative action against Urban Power USA, Inc., a startup electric wind turbine company, for a restraining order to permanently cease and desist making a $500,000 offering of unregistered securities through, among others, its website, Facebook, Younoodle, and Go Big Network, and to make rescission offers to all Massachusetts residents who purchased securities in that offering.
1 H. R. 3606, One Hundred Twelfth Congress of the United States of America, Second Session.
2 JOBS Act, Section 201(a)(1).
3 JOBS Act, Title III, also known as the “Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act of 2012,” or the “CROWDFUND Act.” JOBS Act, Section 301.
4 JOBS Act, Section 302(b), amending the Securities Act of 1933 by adding Section 4A(a)(2). Also, as to funding portals, Section 304(a)(1), amending the Securities Exchange Act of 1934 by adding Section 3(h)(1)(B).
5 JOBS Act, Section 302(b), amending the Securities Act of 1933 by adding Section 4A(a)(1).
6 At the date of this writing (the first week of April, 2012), the SEC has still not adopted rules to implement the rule amendments for disqualification of felons and other “bad actors” from Rule 506 offerings mandated to be effective by July 21, 2011 by Section 926 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank Act”).
7 This disqualification under the Dodd-Frank Act is not yet effective. See the proposing release, Release No. 33-9211, and Section 926 of the Dodd-Frank Act.
8 JOBS Act, Section 302(d).
9 JOBS Act, Section 302(b), amending the Securities Act of 1933 by adding Section 4A(f).
10 JOBS Act, Section 302(a).
11 JOBS Act, Section 302(b), amending the Securities Act of 1933 by adding Section 4A(g).
12 See the discussion of the integration doctrine for Regulation D offerings set forth in SEC Rule 502(a).
13 Use of a separate class of stock for the crowdfunding round might allow a small business incorporated in Washington to make use of the share exchange provisions of the Washington Business Corporation Act (see RCW 23B.11) to subsequently compel redemption of all of the crowdfunded shares if subsequent venture capital or angel investors were willing to invest funds to “clean up” the company’s capital structure, although many venture capital and angel investors are reluctant to provide funds for such purpose, preferring to have all invested funds be applied towards growing the operations of the business.
14 Securities Act of 1933, as amended, Section18.
15 JOBS Act, Section 305.
16 JOBS Act, Section 302(b), amending the Securities Act of 1933 by adding Section 4A(b)(3).
17 JOBS Act, Section 302(b), amending the Securities Act of 1933 by adding Section 4A(b).
18 Full disclosure: the author, working with the Washington securities administrator in 1982, was the principal draftsperson of the form that later became NASAA’s question-and-answer Form U-7 and the SEC’s Offering Circular Model A.
19 E.g., Rule 10b-5 under the Securities Exchange Act of 1934 and RCW 21.20.010 of the Securities Act of Washington.
20 JOBS Act, Section 302(b), amending the Securities Act of 1933 by adding Section 4A(c).
21 This disqualification under the Dodd-Frank Act is not yet effective. See the proposing release, Release No. 33-9211, and Section 926 of the Dodd-Frank Act.
22 JOBS Act, Section 302(d).
23 JOBS Act, Section 302(b), amending the Securities Act of 1933 by adding Section 4A(a).
24 JOBS Act, Section 302(b), amending the Securities Act of 1933 by adding Section 4A(a)(5).
25 JOBS Act, Section 302(b), amending the Securities Act of 1933 by adding Section 4A(a)(6).
26 JOBS Act, Section 302(b), amending the Securities Act of 1933 by adding Section 4A(a)(7).
27 JOBS Act, Section 302(b), amending the Securities Act of 1933 by adding Section 4A(a)(8).
28 JOBS Act, Section 302(b), amending the Securities Act of 1933 by adding Section 4A(a)(4).
29 JOBS Act, Section 303.
30 JOBS Act, Section 302(b), amending the Securities Act of 1933 by adding Section 4A(e).
31 JOBS Act, Section 303.
32 JOBS Act, Section 302(b), amending the Securities Act of 1933 by adding Section 4A(a)(10).
33 JOBS Act, Section 302(b), amending the Securities Act of 1933 by adding Section 4A(a)(9).
34 JOBS Act, Section 302(b), amending the Securities Act of 1933 by adding Section 4A(a)(11).
35 JOBS Act, Section 304(b), amending the Securities Exchange Act of 1934 by adding Section 3(a)(80).
36 JOBS Act, Section 302(b), amending the Securities Act of 1933 by adding Section 4A(b)(2). S e c u r i t i e s L a w U p d a t e A p r i l, 2 0 1 2
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