On Wednesday, October 23, the SEC, at long last, formally proposed rules which would allow companies to offer and sell securities through crowdfunding, as contemplated by the JOBS Act. Crowdfunding is an innovative way for small companies and entrepreneurs to solicit investments from a multitude of investors over the internet. Under Title III of the JOBS Act, legislation enacted in 2012 aimed at spurring small business growth by easing restrictions on capital-raising, Congress created an exemption in the securities laws to permit crowdfunding offerings. The rules were directed to be finalized within 270 days after the JOBS Act was enacted, but have been delayed due to changes in SEC leadership, an exceptionally crowded rule-making agenda at the SEC and the inherent challenges in addressing the many new issues raised.
Under previous SEC regulations, companies engaged in private placements—that is, securities offerings not registered with the SEC—were generally limited in the manner in which they could sell securities and with respect to whom they could sell securities. For example, a popular method, Rule 506, only permitted sales to “accredited” investors (including individuals with a net worth of $1 million or with an annual income over $200,000) and a limited number of unaccredited investors, and prohibited companies from using “general solicitation” to market their private offering, which precluded general advertising of the offering and required that offers only be made to investors with whom the issuer had a pre-existing relationship. Other JOBS Act rulemaking has eliminated the ban on general solicitation for certain Rule 506 offerings, but only for offerings limited to accredited investors. Under the proposed crowdfunding rules, companies taking advantage of crowdfunding would be able to publicly solicit investments through SEC-regulated broker-dealers or crowdfunding portals and access all investors, regardless of their net worth or annual income, subject to the limits described below.
While crowdfunding is aimed at opening up access to capital, the SEC is also seeking to balance protecting investors from fraud. The proposed rules include investor thresholds, limitations on the amount of money companies may raise through crowdfunding, and company disclosure requirements. Individuals who wish to invest in crowdfunding through an online portal will be required to disclose their income or net worth, and the portal will block individuals from investing over certain thresholds. An investor with an annual income of less than $100,000 would be subject to a threshold of $2,000 or 5% of their annual net income or net worth, whichever is greater. An investor with an annual income greater than $100,000 would be subject to a threshold of 10% of their annual income or net worth, whichever is greater. Investors are prohibited from purchasing more than $100,000 of securities through a crowdfunding offering in a year. Additionally, investors would not be able to resell securities purchased through crowdfunding for a one year period. Under the proposed rules, issuers are limited to raising $1 million through crowdfunding in any one year period.
Companies taking advantage of crowdfunding would be required to file certain information with the SEC, and provide it to potential investors and crowdfunding portals. These disclosures would require information about:
- officers, directors and owners of 20% or more of the company;
- the company’s business and how the company is going to use the funds raised;
- the price of securities being offered;
- the target offering amount and deadline to reach that amount, and whether the company will accept investments in excess of that amount;
- the company’s financial condition; and
- the company’s financial statements, which must be audited if the company is seeking to raise more than $500,000.
Companies would have a continuing obligation to update the information with any material changes and provide updates on reaching the target offering amount. Companies raising capital through crowdfunding would also be required to file an annual report with the SEC and make the report available to investors. Many commentators have expressed fears that small businesses will find these disclosure requirements too burdensome to make crowdfunding a worthwhile endeavor.
The proposed rules also require the securities to be offered through either an SEC-registered broker-dealer or a crowdfunding portal, which is a new designation from the JOBS Act. These intermediaries would be required to provide investors with informational materials about the companies, implement measures to reduce the risk of fraud, and provide forums for investors to discuss offerings. Under the proposed rules, the intermediaries would be prohibited from offering investment advice or recommendations, soliciting purchases or offers, and holding or handling investor funds or securities. Crowdfunding portals will also be subject to registration with and significant regulation by FINRA, which released its own proposed rules for comment on the same day as the SEC release.
Certain companies may not utilize the crowdfunding exemption under the proposed rules. These companies include non-U.S. companies, SEC reporting companies, certain investment companies, disqualified companies, companies not in compliance with the annual reporting requirements, companies without a business plan, and companies who plan to engage in a merger or acquisition with an unidentified company.
The proposed rules now enter a 90-day comment period. Given the intense interest of commentators in this part of the JOBS Act to date, coupled with the proposing release containing 295 specific issues on which the SEC invites comment, it is likely that debate will continue well beyond this 90-day period.