April 26, 2012
Special Forum: JOBS Act - Introducing the CROWDFUND Act
Posted by joanheminway

Bob has done yeoman's work in introducing the first three days of this forum.  (Do I hear applause in the background?  I think so.)  Today, it's my turn to introduce the final key piece of the JOBS Act: the CROWDFUND Act, the subject of Title III of the JOBS Act.

I will not try to unpack crowdfunding as a whole in this post.  I will leave that to the articles I cited in my initial post for this forum and to many Web-based destinations with which you may be familiar (or can easily find).  Suffice it to say, crowdfunding involves the use of the Internet to solicit funding for businesses and projects from the faceless Internet "crowd."  It's the fund-raising variant of crowdsourcing; the effective use of social media to connect businesses and projects with potential and actual funding sources.

Instead, I will focus this post on the basic elements of crowdfund investing--the offer and sale of securities to the crowd over the Internet--as contemplated and permitted under the CROWDFUND Act.  Set forth below are the key regulatory components mandated in the CROWDFUND Act, all of which are subject to significant definition, interpretation/illumination, and enhancement by the SEC (within 270 days after the date of enactment of the JOBS Act).

The Basic Parameters for Issuers and Investors

The CROWDFUND Act establishes a new exemption from registration under the Securities Act of 1933 (the "1933 Act"). The new exemption allows issuers to sell up to $1 million of securities in a 12-month period (looking back) without 1933 Act registration.  Under the exemption, an investor is limited in the amount he, she, or it can invest.  If an investor's annual income or net worth is less than $100,000, the investor may invest up to the greater of $2,000 or 5% of that annual income or net worth. If an investor's annual income or net worth is equal to or more than $100,000, the per-investor cap equals 10% of the annual income or net worth, not to exceed a maximum aggregate amount sold of $100,000.  These dollar amounts must be revisited by the SEC at least every five years.

Issuers must be "qualified" in certain respects in order to offer securities in a crowdfunded offering. Specifically, an issuer must be organized under and subject to the laws of a U.S. state or territory or the District of Columbia, and public companies, investment companies, and "bad boys" (issuers that have committed certain violations--e.g., securities law violations) need not apply.

As is true in other federal securities law contexts, an issuer availing itself of the crowdfunding exemption is responsible for certain mandatory disclosures about Itself (including its capital structure and financial information), its principals, the purpose and use of proceeds of the offering, the offering amount, and the pricing and terms of the units being sold.  The financial statement review provisions are among the most controversial under the CROWDFUND Act.  –Financial information must undergo a formal review by an independent accountant for offerings over $100,000 and an audit for offerings over $500,000.  Issuers also are required to comply with certain advertising limits, promotion compensation restrictions, and periodic reporting requirements.

Finally, issuers must subject themselves to a new Section 12(a)(2)-type liability regime.  Oh, and for the purposes of this new material misstatements and misleading omissions liability, the term "issuer" includes the issuer's directors or partners, CEO, and CFO.  So, any of them can be held liable as a primary violator.

Investors are subject to a one-year transfer restriction on any securities acquired in a crowdfunded offering, except for transfers to the issuer, to accredited investors, in a registered offering, to a family member, on death, or on divorce.  And, as you know from Bob's post and my post on the new Section 12(g) thresholds and exemptions under the JOBS Act, record holders of securities issued in a crowdfunded offering are not counted for purposes of those thresholds.

A Mandated Role for Intermediaries

Crowdfunded offerings must be conducted through a specified intermediary--either a registered broker or a registered funding portal--a new type of registered, regulated entity created under the CROWDFUND Act by amendment of both the 1933 Act and the Securities Exchange Act of 1934 (the "1934 Act").  Under the 1934 Act, these funding portals have a limited scope of permitted activities, and while they are are exempt from registration as a broker or dealer, they are subject to regulation as members of national securities associations, to some extent.  In essence, the broker or funding portal is a registered, regulated mandatory participant responsible for advertising and marketing and conducting the offering.

Intermediaries, like issuers, are subject to many obligations in connection with their role in the offering.  Like issuers, these intermediaries are subject to certain mandatory disclosure requirements.  Each intermediary also is responsible, however, for:
  • ensuring investor review of required investor-education materials and understanding of the risk of the offering,
  • implementing fraud risk reduction of some kind,
  • funneling issuer information to the SEC and investors,
  • ensuring that the offering proceeds are held until a specific funding target is met,
  • ennsuring compliance with the investment limits (per-investor caps) described above,
  • instituting investor privacy protections,
  • not selling investor information, and
  • preventing self-dealing by its principals.

The required involvement of a registered broker or funding portal, together with the misstatements and omissions liability and mandatory disclosures included in the CROWDFUND Act, constitute the key investor and market protection tools provided for in the legislation.

Interactions with State Blue Sky Laws

Crowdfunded securities are “covered securities” and, as such, are exempt (preempted) from state registration requirements.  While states are permitted to require notice filings (as with other covered securities), they are not permitted to charge filing fees.  In addition, funding portals are exempt from additional state-level registration requirements.  The CROWDFUND Act requires that issuer mandatory disclosures be made available to state securities commissions and preserves state enforcement authority (authority to investigate and bring enforcement actions) in connection with crowdfunded offerings with respect to (1) fraud or deceit or (2) unlawful conduct by a broker, dealer, funding portal, or issuer.

Two Additional Points

Although this post is intended to be almost wholly descriptive of the congressional pronouncements in the legislation as enacted, I will make two general additional points here--points that emanate to a great extent from what is not in the CROWDFUND Act.  First, there is no restriction on general solicitation and advertising, although it must be done by the intermediary and not the issuer.  Second (and getting very little play in the public media), it is significant that the CROWDFUND Act does not limit the type of security that may be offered and sold in a crowdfunded offering or the terms of that security.  An issuer may offer and sell common stock, preferred stock, debt, investment contracts, or anyother instrument classified as a security.  This includes convertibles and exchangeables, redeemables, etc.  This latter aspect of the legislation is, in my view, an invitation to standard funders (seed, angel, venture capital, etc.) to create new funding pathways/trajectories for early stage firms.  But I will leave it there for now, reserving the right to jump in later with a secnd post or comments to posts of others.

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