A very important and exciting piece of legislation just passed the House and Senate, and on April 5, 2012, received President Obama’s signature. The legislation is all about creating jobs for American workers by allowing businesses to raise capital through avenues currently prohibited or limited by regulations enforced by the SEC.
The JOBS Act, which stands for the “Jumpstart Our Business Startups Act,” gives small business new ways to raise capital, and gives every-day Americans the chance to invest in small business opportunities that would normally be reserved for wealthier investors known as “accredited investors.”
The most widely discussed aspect of the JOBS Act is a new exemption from securities registration called the “CROWDFUNDING” exemption.[1. The “CROWDFUND Act” stands for the “Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act of 2012.”] Issuers who have been living within the four corners of the traditional private placement exception of Section 4(2) of the Securities Act of 1933 (the “’33 Act”), and the safe harbors of Regulation D may soon be able to raise capital under a newly created 4(6) exemption.
That said, the 4(6) Crowdfunding exemption is tricky and a bit burdensome:
First, there is a hard $1M cap on the aggregate amount of securities sold by an issuer to investors in the 12-month period preceding the 4(6) issuance.
Second, there are limitations on how much investors can invest based on their annual income or net worth: the greater of $2,000 or 5% of annual income or net worth for investors whose annual income or net worth is below $100K, and 10% of annual income or net worth where the investor’s annual income or net worth is equal to or above $100K. As a result, crowdfunding is likely to result in financings involving a larger number of small investors, which can lead to a complicated capital structure for a privately held company. In other words, crowdfunding can only be used to raise up to $1M, and potentially through a series of small transactions.
Third, the 4(6) issuance must be conducted through a registered broker or a new type of intermediary known as “funding portals.” A funding portal is an intermediary that does not (a) offer investment advice; (b) solicit purchases, sales or offers to buy the securities offered or displayed on its website or portal; (c) compensate anyone based on the solicitation or sale of securities; or (d) hold, manage, possess or otherwise handle investor funds or securities.
Furthermore, the CROWDFUND Act places strict requirements on the intermediaries involved in 4(6) issuances, which, among others, include the following: (a) the intermediaries must be registered with the SEC as either a broker, or funding portal; (b) the intermediaries must positively affirm the investors’ understanding the risks of investment, including illiquidity and the potential loss of the entire investment; (c) the intermediaries must perform background and regulatory history checks on each officer, director or 20%+ shareholder of the Issuer; (d) the intermediaries must make the Offering Materials of the Issuer available to the SEC within 21 days of the first sale of securities; (e) the intermediaries must ensure that the offering proceeds are not accessible to the issuer until the offering as closed at not less than its targeted amount.
Finally, the CROWDFUND Act also places strict disclosure requirements on issuers, which amount to what one would find in a very thorough private placement memorandum. Issuers are also required to provide annual reports and financial statements to investors. Issuers are not allowed to advertise the terms of their offering, but they are allowed to publish notices directing investors to the funding portal or broker.
It is too early to fully appreciate the impact crowdfunding will have on startups and small businesses looking to raise capital. With investment limitations and a gauntlet of legal loopholes to jump through, crowdfunding doesn’t necessarily open the flood-gates to investment by non-accredited investors. That said, it does provide issuers much-needed access to capital from a much broader demographic, and it promotes investments in small businesses and startups.
The SEC has one year to issue final regulations implementing the crowdfunding legislation, so here at Ashbaugh Beal, we will be following crowdfunding developments closely and monitoring how the SEC interprets and enforces these new laws.
However, the JOBS Act is not just about crowdfunding. Seemingly eclipsed by the public attention to crowdfunding are the dramatic and sweeping changes to Offerings conducted under the Section 4(2) safe harbor found in Regulation D, Rule 506: proposing that 506 Offerings would no longer be subject to the Rule 502(c) prohibitions on general solicitation and general advertising, where all purchasers are “accredited investors.”
Rule 506 is a safe harbor designed to give issuers certainty and clarity of their satisfaction of the Section 4(2) requirements. To be exempt from registration under Section 4(2), the issuance of securities cannot involve a public offering. The proposed changes to Rule 506 would now allow for general solicitation, long thought to be the hallmark of a public offering. By relaxing the general solicitation prohibition for Rule 506 Offerings, Issuers are now likely to take their offerings online, and into social media, creating a whole new set of issues for lawyers and securities regulators to consider. There is a 90-day clock for the SEC to enforce the new changes to Rule 506, and we will watch closely to see how the SEC interprets and enforces these new changes, but we expect the SEC to interpret them narrowly.
The SEC is required to promulgate rules to enforce the new legislation, and the clock is ticking, but the market is already responding. Crowdfunding portals are quickly becoming popular and even forming their own self-regulatory organization, CFIRA (the Crowdfund Intermediary Regulatory Association), to monitor this new marketplace, and the SEC is now receiving confidential draft registration statements for Emerging Growth Companies.
The law is evolving at a fast and furious pace. Expect significantly more clarity from the SEC and CFIRA over the next few months.