Crowdfunding: Preparing for New Regulations

Because the medium for crowdfunding, that is the Internet, is widely accessible, crowdfunding may be used to fund companies with relatively high-risk profiles, and attract investors with less investing experience than traditional public securities offerings.

Commentators, such as Todd Crosland, CEO and founder of Seed Equity Ventures, a broker dealer already operating and doing equity raises under the SEC's Regulation D Rule 506(c) rules for general solicitations regarding crowdfunding, have indicated that the purpose and effect of Regulation Crowdfunding “is to allow non-accredited investors the ability to invest in startups, which was once only reserved for the elite few.” Accordingly, Regulation Crowdfunding establishes strict guidelines and limitations for both companies and investors wishing to engage in crowdfunding efforts.

How Crowdfunding Must Be Completed

An offering of securities under Regulation Crowdfunding is required to be conducted through an intermediary, either a broker or a “funding portal.” Regulation Crowdfunding sets up a regulatory framework for these intermediaries, which must register with the SEC (although not as a broker and thereby becoming subject to the broker-related rules and regulations) and be a member of the Financial Industry Regulatory Authority Inc. (FINRA). Intermediaries may not: 1) offer investment advice or recommendations; 2) solicit purchases, sales, or offers to buy securities offered or displayed on its website or portal; 3) compensate employees, agents, or other persons for such solicitation or based on the sale of securities displayed or referenced on its website or portal; 4) hold, manage, possess or otherwise handle investor funds or securities; or 5) engage in such other activities as the SEC, by rule, deems appropriate.

In addition, intermediaries must protect investors by:

• Providing investors with educational materials on how to use the platform.
• Supplying investors with information about the securities being offered, including resale restrictions, investment limitations and relevant information about the issuer.
• Offering communication channels on the portal through which investors may engage in discussions about the offering.
• Explaining the source, form and amount of compensation the intermediary receives for hosting the transactions.
• Taking adequate measures to reduce fraud, including having a reasonable basis for believing an issuer is complying with Regulation Crowdfunding, that the issuer is maintaining accurate records of its securityholders and that investors are in compliance with the investment limitations.
• Furnishing adequate notices and confirmations at each step of the investment process.
• Complying with requirements regarding completion, cancellation or reconfirmation of offerings' requirements.

Limitations Applicable to Crowdfunding

Pursuant to Regulation Crowdfunding, an issuer may only raise up to $1 million in any 12-month period by means of crowdfunding. In calculating the amounts sold for purposes of this threshold, amounts sold by a predecessor or by an entity under common control with the issuer will be aggregated with the amounts sold by the issuer. There is no integration with other offerings however. In other words, an issuer may conduct other exempt offerings around the same time as its crowdfunded offering. In addition, there are no restrictions limiting the type of securities that may be offered and sold in reliance on the crowdfunding exemption. Thus, offerings may take the form of common stock, preferred stock, or another form of equity interest in the issuer or debt.

Not all issuers may take advantage of Regulation Crowdfunding. Those include: issuers who are not organized under the laws of a state or territory of the United States or the District of Columbia; issuers already subject to reporting requirements under the Securities Exchange Act of 1934, as amended; investment companies as defined in the Investment Company Act of 1940 or companies that are excluded from the definition of “investment company” under Section 3(b) or 3(c) of the Investment Company Act; and any additional issuer that the commission prohibits, by rule or regulation, are prohibited from issuing securities pursuant to Regulation Crowdfunding.

Crowdfunding investors are limited in the amount of their investment. An investor may not invest more than an aggregate of $1 million in any 12-month period. This limitation is subject to exceptions based on the investor's net worth and annual income. An investor will be limited to investing: 1) the greater of $2,000 or 5% of the lesser of the investor's annual income or net worth if either annual income or net worth is less than $100,000; or 2) 10% of the lesser of the investor's annual income or net worth, not to exceed an amount sold of $100,000, if both annual income and net worth are $100,000 or more. Further, subject to certain exceptions, securities purchased in a crowdfunding transaction cannot be transferred for one year.

Reporting Obligations

In addition to the limitations imposed on both crowdfunding issuers and investors, issuers are subject to certain disclosure requirements under Regulation Crowdfunding. Issuers will be required to complete a number of disclosure forms, including an initial disclosure about the offering on Form C, amendments to Form C to report material changes (Form C-A), periodic updates on the offering on Form C-U and ongoing annual filings (Form C-AR) until a filing obligation is terminated (Form C-TR).

Basic issuer information will be required to be disclosed on Form C, such as the issuer's name, the form of entity, the jurisdiction of formation, formation date, address, website, number of employees, the issuer's website on which an investor can find the issuer's annual report and the date by which such report will be made available, whether the issuer or any predecessor previously failed to comply with the ongoing reporting requirements of Regulation Crowdfunding. Further, the issuer will be required to set forth a discussion of the business, the use of proceeds, the targeted offering size, the offering price and its directors and officers.

What Liability Do Companies and Intermediaries Risk?

An issuer will be liable to its investors in a crowdfunded transaction if the issuer, in the offer or sale of the securities, makes an untrue statement of a material fact or omits to state a material fact required to be stated or necessary in order to make the statements, in light of the circumstances under which they were made, not misleading. To avoid liability, the issuer must show that it did not know, and in the exercise of reasonable care could not have known, of the untruth or omission. Regulation Crowdfunding also contains a number of safe harbors for nonmaterial deviations from a term, condition or requirement of the regulation.

Conclusion

To what extent crowdfunding will be used to raise capital over the Internet is yet to be seen. Issuers, portals, brokers and advisers must carefully adhere to the rules of Regulation Crowdfunding so as to not neglect or overlook any obligations that may have ramifications on the use of other forms of capital-raising methods that could be essential for an emerging company. The bulletin acts as a summary of the regulations; however, care should be taken in reviewing, understanding and appropriately applying the final rules. In determining whether to conduct an offering in reliance on Regulation Crowdfunding, companies should consult legal counsel and financial experts to confirm that they conduct the offering in compliance with SEC regulation and that they have the finances to support the costs associated with conducting such an offering.

Katayun I. Jaffari is a partner in Ballard Spahr's business and finance department. She can be reached at [email protected] or 215-864-8475. Kimberly W. Klayman is an associate at the firm. She can be reached at [email protected] or 215-864-8792. This article also appeared in The Legal Intelligence, an ALM sibling publication of this newsletter.