JOBS Act Update: Proposed Crowdfunding Rules Nearer to Adoption
As final rules permitting equity-based crowdfunding draw near, we have seen issuers and market intermediaries ramp up efforts to develop platforms able to take advantage of the imminent rule changes. Consider SolarCity, for example, the largest installer of rooftop solar systems in the US. Recently SolarCity purchased Common Assets, a startup financial technology company, to develop a funding portal to crowdfund SolarCity’s ambitious growth projections. SolarCity, like many other rapidly growing companies, is seeking alternative methods to raise capital at cheaper rates. The JOBS Act contained many provisions to allow such alternative methods, including enhanced securities registration exemptions and an equity crowdfunding framework. Almost two years since the JOBS Act was signed into law, the SEC has sought comment on proposed rules to allow crowdfunding of up to $1 million using funding portals. However, it remains to be seen how SolarCity and similarly situated companies will ultimately choose to utilize the new rules.
Title III of the JOBS Act, known separately as the Capital Raising Online While Deterring Fraud and Unethical Non–Disclosure Act of 2012, defines and contains the framework for the new equity crowdfunding regulatory scheme. The framework contains two main components: 1) a new exemption for securities issuances of up to $1 million with significant differences from other small issuance exemptions; and 2) a new brokering entity labeled a “funding portal” that is less regulated than traditional broker-dealers. Title III is not deemed effective until the SEC adopts the proposed rules fleshing out the new framework. Although the comment period on these rules closed on February 4, 2014, the rules may not be adopted for many months afterward as some finer points get hashed out. Thus far commentary has been divided as to whether the rules are too restrictive of crowdfunding in an attempt to provide investor safety or too lenient in an attempt to allow more opportunities to raise capital. Because of the split in thought, it seems likely that the rules as proposed may end up very similar to the final adopted rules.
The proposed rules closely follow and elaborate on the JOBS Act by creating an exemption from registration for issuers of under $1 million in aggregate during a 12-month period, provided such issuers comply with certain criteria. All issuers must disclose basic information such as the legal status, physical address, names of directors and officers, and the business plan of the issuer. For issuances of up to $100,000.00, tax returns and unaudited financial statements of the issuer must be filed with the SEC. For issuances of $100,000.00 to $500,000.00, an independent accountant must review the financial statements. For issuances of $500,000.00 to $1 million, the financial statements must be audited. Other filings required of all issuers include the capital structure of the issuer and the details of the planned offering, such as pricing, risk factors, and intended use of the funds raised. Post-issuance reporting requirements parallel the filing requirements. Additionally, advertising and solicitation by the issuer is banned, although notice directing potential offerees to a broker or funding portal is allowed.
Certain restrictions disqualify issuers from using the crowdfunding exemption. First, bad actor provisions follow those applied to other registration exemptions. Second, issuers that have already issued registered securities may not utilize the crowdfunding exemption. Third, certain types of investment, acquisition and blank check companies are not allowed to raise money using the crowdfunding exemption.
The JOBS Act also restricts the amount of investment by individual investors in securities offered under the crowdfunding exemption. The proposed rules closely follow the outline of the statute, but clarify that the maximum investment by individuals is $2,000.00 or 5% of such individual’s annual income in one year, whichever is greater, if both annual income and net worth are below $100,000.00. If either annual income or net worth is above $100,000.00, up to 10% of the greater of annual income or net worth may be invested, up to a maximum of $100,000.00. Net worth is calculated in the same manner as the determination of accredited investor status. Annual income and net worth may be determined on an individual or joint basis in the case of married persons. Additionally, issuers may rely on intermediaries to ensure that investors don’t surpass investment caps.
Issuers wishing to take advantage of the crowdfunding exemption are required to sell securities through an intermediary. This intermediary can include traditional brokers or newly defined funding portals. The JOBS Act permits funding portals to be exempt from the same registration requirements as brokers, but they must still belong to a national securities association (likely FINRA). Funding portals are also much more limited in scope and role than traditional brokers; they are restricted from soliciting orders, holding or managing investor funds, or offering investment advice. Only one offering and one intermediary may be used at any one time. Additionally, entities under common control will be considered a single issuer.
Under these basic guidelines it seems unlikely that most growing companies will be able to raise enough capital to finance ambitious growth. Fortunately, the SEC has proposed that the crowdfunding exemption can be used in addition to other registration exemptions, without altering the validity of the exemptions. With the recent alterations to other exemptions (specifically Regulation D and Regulation A+ offerings), the greatest challenge may be finding counsel to help navigate the new landscape.