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SEC Adopts Final Crowdfunding Rules

On October 30, 2015, the Securities and Exchange Commission (“SEC”) adopted final crowdfunding rules as required by Title III of the Jumpstart Our Business Startups Act (“JOBS Act”). The proposed crowdfunding rules were released just over two years ago and resulted in more than 485 comment letters. The rules, called “Regulation Crowdfunding,” will become effective 180 days after publication in the Federal Register.

Crowdfunding in the U.S. has generally not involved the offer of shares in financial returns or profits from the fundraiser’s business activities because such an offering would involve the offer and sale of a security and trigger application of the federal securities laws. Under the Securities Act of 1933 (the “Securities Act”), the offer and sale of securities must be registered unless an exemption from registration is available. Typically, registration was not feasible for such crowdfunding offerings due to the costs of conducting a registered offering and the resulting ongoing reporting obligations. Private placement exemptions from registration were generally not available due to, among other things, purchaser qualification requirements.

Regulation Crowdfunding now permits companies to raise capital through crowdfunding transactions, which are transactions in which companies solicit individual contributions from a large number of people via the Internet. The intended beneficiaries of the newly exempted equity crowdfunding model are small businesses and early-stage start-ups that generally would not attract venture capital or have access to other capital investments. Regulation Crowdfunding may act to democratize capital-raising and open up the possibility for investment in less historically desirable ventures, such as women- or minority-founded businesses. However, the tension between facilitating the raising of capital by smaller companies and the need for investor protection is clear in the new rule. The investment caps and disclosure requirements (including the provision of GAAP-compliant financial statements) embedded in the rule for the protection of small, possibly unsophisticated, investors may make compliance too costly for the small start-ups intended to benefit from the rule. Although efforts were made in the final rule to reduce the burden on small companies, the compliance demands will be substantial. Additionally, start-ups that engage in crowdfunding offerings may end up with a large and diverse base of investors not otherwise affiliated with the company, resulting in additional costs related to administration and difficulties obtaining stockholder approval of later transactions.

No later than three years from the effective date of Regulation Crowdfunding, the SEC staff has agreed to study and submit a report on the impact of the rule on capital formation and investor protection. Until then, we can expect to see further interpretation and enforcement of the rule as the SEC seeks to balance the desire to open up the capital markets against the need for investor protection.

Investment Limits

The new rules implement Title III of the JOBS Act and now permit individuals to invest in securities-based crowdfunding transactions, subject to certain limitations prescribed by the JOBS Act. Regulation Crowdfunding exempts from registration under the Securities Act crowdfunding transactions for certain issuers that meet the following requirements:

  • The total amount raised by an issuer via crowdfunding must not exceed $1 million in any 12-month period;
  • Individual investments in all crowdfunding issuers in any 12-month period are limited to:
    • The greater of (i) $2,000 or (ii) 5% of the lesser of their annual income or net worth (if annual income or net worth of the investor is less than $100,000); and
    • 10% of the lesser of their annual income or net worth, not to exceed $100,000 (if annual income and net worth of the investor is $100,000 or more);
  • During any 12-month period, the aggregate amount of securities sold to an individual investor via crowdfunding may not exceed $100,000; and
  • Transactions must be conducted through an “intermediary” that is either registered as a broker-dealer or as a “funding portal.”

The SEC provided an illustrative chart showing the investment limit for certain investors:

Investor
Annual Income
Investor
Net Worth
Calculation Investment
Limit
$30,000 $105,000 Greater of $2,000 or 5% of
$30,000 ($1,500)
$2,000
$150,000 $80,000 Greater of $2,000 or 5% of
$80,000 ($4,000)
$4,000
$150,000 $100,000 10% of $100,000 ($10,000) $10,000
$200,000 $900,000 10% of $200,000 ($20,000) $20,000
$1,200,000 $2,000,000 10% of $1,200,000
($120,000), subject to $100,000 cap
$100,000

The intermediary must have a reasonable basis for believing that an investor satisfies those investment limits. Issuers are entitled to rely on the intermediary’s determination, provided the issuer does not have knowledge otherwise.

Issuer Eligibility

Regulation Crowdfunding is not available to certain companies, including: non-US companies, companies that are already Exchange Act reporting companies, certain investment companies, companies that are disqualified under the regulation’s “bad actor” disqualification rules, companies that have not complied with the annual reporting requirements of the regulation during the two years preceding the filing of the offering statement, and companies that have no specific business plan or whose business plan is to engage in a merger or acquisition with an unidentified company or companies.

Disclosure

Offering Documents

In order for issuers to take advantage of Regulation Crowdfunding, they must provide certain specified disclosure to the SEC, investors and brokers or funding portals. The new disclosure must be filed with the SEC on a new Form C, which must be filed in the eXtensible Markup Language (“XML”) via EDGAR.

An issuer conducting an offering pursuant to Regulation Crowdfunding will be required to disclose in the offering documents:

  • its legal status, physical address and website address;
  • information about its directors, officers and 20% owners;
  • a description of the issuer’s business (including its current number of employees), anticipated business plan, the use of proceeds from the offering and material risk factors;
  • the price to the public of the securities (or method for determining the price);
  • the target offering amount, the deadline to reach that amount, and whether the issuer will accept investments greater than that amount and the maximum oversubscription and method of allocation;
  • a description of the ownership and capital structure of the issuer (including risks related to minority ownership and potential dilution), the material terms of any indebtedness and any exempt offerings conducted within the past three years;
  • related-party transactions;
  • a description of the issuer’s financial condition (including, to the extent material, a discussion of liquidity, capital resources and historical financial results); and
  • financial statements for the two most recently completed fiscal years or the period since inception, if shorter.

Regulation Crowdfunding includes a tiered level of financial disclosure in the offering document and financials must be prepared in accordance with U.S. GAAP:

  • For issuers offering $100,000 or less, issuers must include the amount of total income, taxable income and total tax (or equivalent items) as reported on its federal tax returns and financial statements certified by the company’s principal executive officer. If the issuer has financial statements that have been reviewed or audited by an independent public accountant, it must provide those instead of financial statements certified by the principal executive officer and need not provide the tax information.
  • For issuers offering more than $100,000 but not more than $500,000, or which are offering more than $500,000 (but not more than $1 million) in reliance on Regulation Crowdfunding for the first time, issuers must include financial statements reviewed (but not audited) by an independent public accountant. An issuer that has audited financial statements must provide those instead of reviewed statements.
  • For issuers offering more than $500,000 that have previously sold securities in reliance on Regulation Crowdfunding, issuers must include financial statements audited by an independent public accountant.

Issuers must also include certain information regarding the intermediary (including any compensation to be paid) and specific disclosures regarding the investment process mandated by Regulation Crowdfunding. The SEC may require additional disclosures for the protection of investors and in the public interest.

Annual Reports

Issuers must make annual reports updating the issuer information in the offering documents, which must be posted on their websites. The annual report must be filed within 120 days after the fiscal year and include financial statements certified by the issuer’s principal executive officer. If the issuer has financial statements reviewed or audited by an independent public accountant, those must be posted and the officer certification is not required. The annual report requirement terminates when the issuer becomes a reporting company under the Exchange Act, holders of record drop below 300 or total assets do not exceed $10 million after specified periods, when all securities issued pursuant to Section 4(a)(6) are purchased by the issuer or another party, or the issuer liquidates or dissolves.

Funding Portals

Issuers may not engage in crowdfunding through their own websites. Instead, issuers are required to conduct crowdfunding offerings through either a broker or a funding portal. The term “broker” is defined in Exchange Act Section 3(a)(4) as a person that effects transactions in securities for the account of others. A “funding portal” is a new intermediary that facilitates a transaction involving the offer or sale of securities for the account of others, pursuant to Securities Act Section 4(a)(6). An issuer may choose only one intermediary to conduct an offering under Regulation Crowdfunding, which the SEC believes will better foster the creation of a “crowd.”

Funding portals are required to register with any applicable self-regulatory organization, must be a member of a national securities association registered with the SEC (i.e., FINRA), and are required to take certain actions in connection with the crowdfunding offering, including providing investors with materials that explain the investment process and the securities being offered. Funding portals must take affirmative steps to reduce the risk of fraud and may not provide issuers with access to their platforms if they have a reasonable basis for believing that the issuers have the potential for fraud. The funding portals will be required to have a reasonable basis to believe that the issuers have established methods to keep accurate records of their security holders.

Funding portals are prohibited from offering investment advice, making recommendations, soliciting purchases or offers to purchase securities or compensating other for doing so, holding or managing investor funds. Funding portals and their officers, partners and directors may not have a financial interest in an issuer using its platform.

Advertising

Issuers engaging in offerings pursuant to Regulation Crowdfunding may publish an advertising notice stating that the issuer is conducting an offering; the intermediary through which it is being conducted and a link to the intermediary’s platform; the terms of the offering; and factual information about the issuer.

Resale

Securities purchased in a crowdfunding transaction are generally subject to a holding period of one year before they can be sold. There are limited exceptions to this prohibition, including resales to the issuer, sales to accredited investors, or sales to the investor’s family or as part of a registered offering.

State Blue Sky Laws

Offerings conducted pursuant
to Regulation Crowdfunding will be exempt from registration requirements under
state securities laws.

***

Regulation Crowdfunding imposes detailed disclosure and compliance obligations on issuers and intermediaries, which are only briefly summarized above. For any questions or greater clarity on the new rules, please contact the Hinckley Allen attorney with whom you regularly work.

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